The Role of Individual Personal Saving Accounts In Social Security Reform

Social Security’s Financing Problem

Most Americans recognize that Social Security faces a long-term financing problem. Many workers under 35 believe the problem is so severe they will never receive a Social Security check.

Young workers lack confidence in Social Security because they do not believe future workers will be willing to shoulder the higher payroll taxes that will be needed to keep the program solvent. I think they are wrong, but their fears are not unreasonable. For almost two decades many influential opinion leaders and elected officials have fiercely criticized any increase in taxes, even when it was plain that future Social Security revenues will fall far short of promised future benefits. If the Congress and public are opposed to boosting taxes today, when the tax increase required to eliminate Social Security’s long-run deficit is relatively small, will they be willing to raise taxes after 2020, when the required tax increase would be far larger? Younger workers and many opinion leaders evidently do not think so.

The simplest and best solution to Social Security’s financing problem is to trim promised benefits and increase payroll taxes one or two percentage points. It would be sensible if major steps along these lines were taken well in advance of 2010 when the Baby Boom generation begins to retire. Although it is not necessary that future benefits be reduced or taxes hiked immediately, it is desirable that decisions about future benefits and taxes be made as soon as possible. The OASDI Trustees’ intermediate assumptions imply that the Trust Funds will be depleted shortly after 2030. The youngest Baby Boom workers will be in their middle 60s when that year arrives. If workers are to plan sensibly for their retirement, it is critical to inform them what combination of reduced benefits or higher taxes they will face over their careers.

The long-run threat to Social Security solvency has prompted many people to offer novel solutions to the financing problem. Some proposals are aimed at reducing or eliminating the role of Social Security in protecting the incomes of the disabled and retired elderly. Others have the simpler goal of improving the financial performance of the Social Security Trust Funds by permitting Trust Fund reserves to be invested in equities or other high-yielding assets.

Individual Accounts

One of the most widely discussed reform plans is to scale back traditional Social Security benefits and replace them fully or partially with a privately managed system of individual retirement accounts. Such accounts could be run independently of traditional Social Security or as an additional component of the existing system. Proponents of individual accounts offer three main arguments for moving toward individual pension accounts:

  • It can lift the rate of return workers earn on their retirement contributions
  • It can boost national saving and future economic growth
  • It has practical political advantages in comparison with reforms in existing public programs that rely on higher payroll taxes or a bigger accumulation of public pension reserves

Moving to a system of large individual accounts must overcome a big financial hurdle, however. The existing Social Security system has already accumulated huge unfunded liabilities to workers who are already retired or who will retire in the next couple of decades. To make room for a new individual account system, the Nation must find public funds to pay for existing Social Security obligations while still leaving young workers enough money to deposit in new retirement accounts. This requires scaling back current obligations—by cutting benefits—or increasing total contributions from current workers. A large-scale individual account system would almost certainly require major new public borrowing. The country has struggled for the past decade to eliminate the federal deficit, so many voters will be angry to see that accomplishment thrown away in order to make room for a new system of individual accounts.

As noted, proponents of individual accounts claim both economic and political advantages for their favorite plans. In the remainder of my testimony, I focus on the economic aspects of such proposals.

Individual saving accounts can boost workers’ rate of return by allowing their retirement contributions to be invested in private assets, such as equities, which yield a better return than the assets held by Social Security. Returns can be boosted still further if the U.S. government borrows on a massive scale to pay for past public pension liabilities, allowing workers to invest a larger percentage of their wages in high-yielding assets. Exactly the same rate of return can be obtained, however, if the existing Social Security system is changed to allow reserves to be invested in high-return private assets. Put simply, the rate-of-return advantage claimed for individual accounts could be duplicated by the present system if its investment options were expanded.

By shifting the retirement system away from pay-as-you-go financing and toward advance funding, a system of individual accounts could boost national saving. Such a move will require a consumption sacrifice, either through a cut in benefits or a hike in combined contributions to the old and new retirement plans. Individual account plans that do not impose a consumption sacrifice will not achieve a higher saving rate. Higher national saving can also be achieved by reforming the present Social Security system. The crucial change in policy is the move toward more advance funding, not the move to individual accounts. Thus, the claimed economic advantages of individual retirement accounts can be obtained in either a new individual account system or with a slight modification of the existing Social Security system.

In an individual account system workers would be free to decide how their contributions are invested, at least within broad limits. Some proponents of individual account plans suggest that contributions should be collected by a single public or semi-public agency and then invested in one or more of a limited number of investment funds. A worker might be given the option of investing in, say, five different funds—a money market fund, a stock market index fund, a real estate investment trust, a corporate bond fund, and a U.S. Treasury bond fund. By pooling the investments of all covered workers in a small number of funds and centralizing the collection of contributions and funds management, this approach minimizes administrative costs but it limits workers’ investment choices. Another strategy is to allow mutual fund companies, private banks, insurance companies, and other investment companies to compete with one another to attract workers’ contributions in hundreds or even thousands of qualified investment funds. This strategy would permit workers unparalleled freedom to invest as they choose, but the administrative, enforcement, and selling costs of such a system would be very high, substantially reducing the rate of return workers earn on their investments.

Transition to an Individual Account System

Individual account plans differ from traditional Social Security in two important ways. First, the worker’s ultimate retirement benefit depends solely on the size of the worker’s contributions and the success of the worker’s investment plan. Workers who make larger contributions receive bigger pensions, other things equal. Workers whose investments earn better returns will get much larger pensions than workers who invest poorly. Second, in an individual account system pensions will be paid out of large accumulations of privately owned savings. In contrast, current Social Security pensions are financed mainly by the payroll taxes of active workers. This difference between the two kinds of system implies that the savings accumulation in an individual-account plan would be many times larger than the accumulation needed in pay-as-you-go Social Security.

Because the connection between individual contributions, investment returns, and pension benefits is very straightforward in a defined-contribution individual account program, the system offers less scope for redistribution in favor of low-wage workers. Pensions financed out of individual investment accounts are based solely on deposits into the accounts (which are strictly proportional to workers’ earnings) and on the investment performance of the accounts. Redistribution in favor of low-wage or other kinds of workers must take place outside these accounts. In contrast, the Social Security pension formula explicitly favors low-wage workers and one-earner married couples in order to minimize poverty among elderly and disabled people who have worked for a full career. To duplicate Social Security’s success in keeping down poverty among the elderly and disabled, an individual account system must supplement the pensions from the individual accounts with a minimum, tax-financed pension or with public assistance payments.

The United States cannot immediately scrap its public retirement system and replace it with a private system. At the end of 1997, almost 44 million Americans were collecting benefits under Social Security. About 2.3 million workers began to collect new retirement or disability benefits during the previous twelve months. Even if the country adopted a new individual account system for workers under 45, people who are already collecting Social Security or who will begin collecting within the next few years will continue to receive Social Security checks for several decades. Public funds must be appropriated to pay for these pensions, regardless of the system established for workers who will retire in the distant future.

Risks of Individual Accounts

The deficit risk. The need to pay for the pensions of people who are already retired or near retirement age poses a challenge to all plans for establishing mandatory individual retirement accounts. Money must be found for existing pension liabilities at the same time workers will be asked to contribute to the new type of pension account. Because active workers will be required to finance pensions for retired workers and old workers nearing retirement, they may resent the obligation to pay for their own retirement pensions through contributions to new individual accounts.

Some individual account plans would fund new retirement accounts by diverting a small part of the present payroll tax into private retirement accounts. In 1997, Social Security tax revenues exceeded OASDI benefit payments by $44 billion, or a bit more than 1% of taxable earnings. Thus, 1% to 1½% of the 12.4% payroll tax could be invested in individual retirement accounts while still leaving enough taxes to pay for current pension payments. This source of financing for the new accounts will not last forever. Even if workers under age 45 were completely excluded from collecting Social Security pensions, benefit payments will exceed Social Security taxes by around 2015. In addition, workers must contribute much more than 1½% of their wages if they hope to accumulate enough private savings to enjoy a comfortable retirement. Thus, the strategy of diverting a small part of Social Security taxes can only work if current benefits are scaled back (yielding a surplus in Social Security long after 2015) or if private pension accounts provide only a modest supplement to Social Security pensions.

More ambitious individual account plans would require borrowing or new federal taxes to pay for existing Social Security liabilities. These plans would divert half or more of the present Social Security payroll tax into private retirement accounts. The Social Security benefits promised to young workers (for example, those under age 45) would be slashed. A high rate of contributions into the new private accounts would be needed to ensure that enough money is accumulated to pay for reasonable pensions. However, the diversion of payroll taxes would starve the Social Security system of revenue, forcing the program to run huge deficits. To cover these deficits Congress would be forced to raise taxes or borrow funds. The need for extra taxes or borrowing would shrink as pensioners collecting Social Security are eventually replaced by pensioners who receive benefits from the new private accounts, but this process would not be complete for several decades. In the interim, the federal government would need to impose extra taxes (temporarily replacing most of the lost Social Security taxes) or run large deficits in order to cover the shortfall in the remaining Social Security program.

Investment risk. The most frequently mentioned advantage of individual accounts is that they would permit workers to earn a much better rate of return than they are likely to achieve on their contributions to traditional Social Security. I have heard it claimed, for example, that workers will earn less than 0% real returns on their contributions to Social Security, while they could earn 8% to 10% on their contributions to an individual retirement account if it is invested in the U.S. stock market.

This comparison is highly misleading. First, the claimed return on Social Security contributions is too low. Some contributors will earn negative returns on their Social Security contributions, but on average future returns are expected to be between 1% and 1½%, even if taxes are increased and benefits reduced to restore long-term solvency.

Second, workers will not have an opportunity to earn the stock market rate of return on all of their retirement contributions, even if Congress establishes an individual account system in the near future. As noted above, more than nine-tenths of workers’ contributions to Social Security are immediately used to pay benefits to disabled and retired workers and the dependents of deceased workers. Even if a new individual account system is established, workers (or other taxpayers) will be obliged to pay the cost of these promised benefits. Thus, the amount of surplus funds available to invest in the stock market is 1½% of a worker’s pay rather than the full 12.4% of payroll that is deducted for Social Security contributions. Workers’ overall rate of return on their contributions to the retirement system will be an average of the return obtained on their contributions to individual accounts and the return earned on their contributions to whatever remains of the traditional Social Security system. For most current workers, this overall rate of return will be much closer to the current return on Social Security contributions than it is to 8%.

Advocates of individual retirement accounts often overlook the investment risk inherent in these kinds of accounts. All financial market investments are subject to risk. Their returns, measured in constant, inflation-adjusted dollars, are not guaranteed. Over long periods of time, investments in the U.S. stock market have outperformed all other types of domestic U.S. financial investments, including Treasury bills, long-term Treasury bonds, and highly rated corporate bonds. But stock market returns are highly variable from one year to the next. In fact, they are more variable over short periods of time than are the returns on safer assets, like U.S. Treasury bills.

Many people mistakenly believe the annual ups and downs in stock market returns average out over time, assuring even the unluckiest investor of a high return if he or she invests steadily over a four- or five-decade period. A moment’s reflection shows that this cannot be true. From January 1973 to January 1975 the Standard and Poor’s composite stock market index fell 50% after adjusting for changes in the U.S. price level. The value of stock certificates purchased in 1972 and earlier years lost half their value in 24 months. The average real rate of return on a worker’s lifetime investments in the stock market plunged more than 3 percentage points (from 8.6% to 5.3%) in a very short period of time. For a worker who planned on retiring in 1975, the drop in stock market prices between 1973 and 1975 would have required a very drastic reduction in consumption plans if the worker’s sole source of retirement income depended on stock market investments.

I have made calculations of the pensions that workers could expect under an individual account plan using information about annual stock market performance, interest rates, and inflation dating back to 1871. I start with the assumption that workers enter the workforce at age 22 and work for 40 years until reaching their 62nd birthdays. I also assume they contribute 2 percent of their wages each year to their individual retirement accounts. Workers’ earnings typically rise throughout their careers until they reach their late 40s or early 50s, and then wages begin to fall. I assume that the age profile of earnings in a given year matches the age profile of earnings for American men in 1995 (as reported by the Census Bureau using tabulations from the March 1996 Current Population Survey). In addition, I assume that average earnings in the economy as a whole grow 1% a year.

While it would be interesting to see how workers’ pensions would vary if they altered the percentage of contributions invested in different assets, in my calculations I assume that all contributions are invested in stocks represented in the Standard and Poor’s composite stock index. Quarterly dividends from a worker’s stock holdings are immediately invested in stocks, too. Optimistically, I assume that workers incur no expenses buying, selling, trading, or holding stocks. (The average mutual fund that holds a broadly diversified stock portfolio annually charges shareholders a little more than 1% of assets under management. Even the most efficient funds impose charges equivalent to 0.2% of assets under management.) When workers reach their 62nd birthdays they use their stock accumulations to purchase a single-life annuity for males. To determine the annuity company’s charge for the annuity, I use the Social Security Actuary’s projected life table for males reaching age 65 in 1995. To earn a secure return on its investments, the annuity company is assumed to invest in long-term U.S. government bonds. I assume that the annuity company sells a “fair” annuity: It does not earn a profit, incur administrative or selling costs, or impose extra charges to protect itself against the risk of adverse selection in its customer pool. (These assumptions are all unrealistic. Annuity companies typically charge an amount that is equivalent to 15% of the selling price of annuities to cover these items.) My assumptions therefore yield an overly optimistic estimate of the pension that each worker would receive.

The attached chart shows the replacement rate for workers retiring at the end of successive years from 1910 through 1997. The hypothetical experiences of 88 workers are reflected in this table. The worker who entered the workforce in 1871 and retired at the end of 1910, for example, would have accumulated enough savings in his individual retirement account to buy an annuity that replaced 19% of his peak lifetime earnings (that is, his average annual earnings between ages 54 and 58). The worker who entered the workforce in 1958 and retired at the end of 1997 could purchase an annuity that replaced 35% of his peak earnings. The highest replacement rate (40%) was obtained by the worker who entered the workforce in 1926 and retired at the end of 1965. The lowest (7%) was obtained by the worker who entered work in 1881 and retired in 1920. Nine-tenths of the replacement rates shown in the chart fall in the range between 10% and 37%. The average replacement rate was 20.7%. (For workers retiring after 1945 the replacement rate averaged 25.3%.)

The principal lesson to be drawn from these calculations is that individual retirement accounts offer an uncertain basis for planning one’s retirement. Workers fortunate enough to retire when financial markets are strong can obtain large pensions; workers with the misfortune to retire when asset prices are low can be left with little to retire on. The biggest pension shown in the chart is more than 5 times larger than the smallest one. Even in the period since the start of the Kennedy Administration, the experiences of retiring workers have differed widely. The biggest pension was 2.4 times the size of the smallest. In the six years from 1968 to 1974 the replacement rate fell 22 percentage points, plunging from 39% to 17%. In the three years from 1994 to 1997 it jumped 14 percentage points, rising from 21% to 35%. Social Security pensions have been far more predictable and have varied within a much narrower range. For that reason, traditional Social Security provides a much more solid basis for retirement planning and a much more reliable foundation for a publicly mandated basic pension.

The uncertainty of individual account pensions is understated in the chart, because it does not take account of the effects of inflation in years after a worker retires. In benign periods, such as the 1950s or the past few years, U.S. inflation has been low and fairly stable. In other periods, such as the 1970s and early 1980s, inflation has been high and erratic. Social Security has spared pensioners from the adverse effects of major jumps in inflation, because benefit payments are indexed. If workers were forced to buy annuities from private firms, this kind of inflation protection would be much harder to obtain. Workers could see big drops in the purchasing power of their annuities when prices started to rise rapidly.

Individual retirement risk. The calculations shown in the table refer to the experiences of workers who consistently invest 2% of their wages in an indexed portfolio of U.S. equities. This investment strategy on average has yielded the highest pension of the alternative investment strategies open to most U.S. workers. If instead the worker had invested a fixed percentage of contributions to corporate or U.S. Treasury bonds, the ultimate pension would have been lower, because the rate of return associated with the alternative strategy is lower than it is when all contributions are invested in equities. Of course, many workers, especially low-wage workers, are too risk averse to invest all their contributions in equities. They would instead invest some or all of their contributions in bonds or even short-term Treasury bills. Workers who selected a lower-return strategy would receive lower pensions than shown in the chart. Some workers might even earn negative returns if they withdrew their investments from stocks or long-term bonds at inopportune times.

The risk that workers might choose a particularly bad investment strategy does not arise under the present Social Security system. That system provides a minimally adequate pension for nearly all workers who make contributions over a full career, regardless of the individual worker’s investment expertise. In my view, that is appropriate in a mandatory public pension. The mandatory pension should provide a secure and adequate retirement income regardless of a worker’s investment expertise. If voters or taxpayers are concerned about the low rate of return earned under the present Social Security system, then the investment strategy of the Social Security Trust Funds should be changed to permit the funds to be invested in higher yielding assets. All of us should recognize, however, that this new investment strategy will expose the Trust Funds to greater short-run risk.


The debate about reforming Social Security should not begin with exaggerated fears about an impending financing “crisis” in the program, but with a reasoned view of the role played by Social Security in protecting the living standards of the old and disabled. For people who are (or expect to be) very well off, the role of Social Security may not be very important. For the great majority of old and disabled Americans, however, the program provides a large percentage of retirement income. Low-income American families containing a person over 64 derive more than three-quarters of their cash income from Social Security. Even among most nonpoor elderly families, more than half of income is derived from Social Security. A large percentage of nonpoor families would be poor were it not for Social Security pensions.

Social Security also provides workers a crucial protection against financial market risk. It is worth remembering that when the system was established in 1935, many industrial and trade union pension plans had collapsed as a result of the 1929 stock market crash and the Great Depression, leaving workers with no dependable source of income in old age. The private savings of many households was wiped out as well. Given these circumstances, it is hardly surprising that a public pension plan, backed by the taxing authority of the federal government, was found to be preferable to sole reliance on individual retirement plans. Financial market fluctuations continue to make private retirement incomes uncertain. As a result, the argument for a continued role for traditional Social Security is strong, even for workers who earn middle-class wages throughout their careers.

The only practical way to reduce the burden on future workers of paying for retirement benefits is to raise future national income. This can be accomplished within the context of retirement policy by increasing national saving, either in the private sector or in the public sector. Many proposals to “fix” the Social Security financing problem by introducing individual retirement accounts boost private sector saving but simultaneously increase the federal deficit by an equivalent amount, leaving national saving unchanged. Some advocates of private pensions have suggested that part of the current Social Security payroll tax be diverted to private pension accounts, thus boosting private saving. Unless federal spending is cut sharply at the same time, this strategy will simply increase the size of the federal deficit, reducing government saving.

The best way to improve the welfare of both young workers and future retirees is to boost national saving so that there will be more future income to divide between future workers and retirees. Some individual retirement account plans can accomplish that goal, but most would not—and many would actually reduce aggregate saving. I cannot see how elimination or sharp curtailment of Social Security pensions could ever improve the prospects of today’s younger workers. Their welfare and confidence in the system could be improved if pensions and contribution rates were promptly adjusted to keep Social Security’s promises in line with its future revenues.