GAO

United States General Accounting Office

Report to the Chairman, Committee on

Ways and Means, House of

Representatives

September 2000 SOCIAL SECURITY

REFORM

Implications for

Private Pensions

GAO/HEHS-00-187

Page 1 GAO/HEHS-00-187 Social Security Reform

Contents

Letter 3

References 36

Figures Figure 1: Percentage Share of Aggregate Cash Income by Retirement

Income Source, Married Couples and Unmarried

Individuals, Age 65 and Older, 1998 10

Figure 2: Retirement Income by Source and Income Quintile,

Households Age 65 and Older, 1998 12

Figure 3: Integration With Social Security in Defined Benefit Plans,

Percentage of Full-Time Participants, 1980-1997 17

Abbreviations

ERIC Erisa Industry Committee

ERISA Employee Retirement Income Security Act of 1974

IRA individual retirement account

OASDI Old-Age and Survivors Insurance and Disability Insurance

OBRA86 1986 Omnibus Budget Reconciliation Act
Page 2 GAO/HEHS-00-187 Social Security Reform
Page 3 GAO/HEHS-00-187 Social Security Reform

United States General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-283947 Letr

September 14, 2000

The Honorable Bill Archer

Chairman

Committee on Ways and Means

House of Representatives

Dear Mr. Chairman:

The projected insolvency of the Social Security1 Trust Funds raises

concerns about our nation’s ability to ensure adequate retirement income

for current and future generations. While the accompanying debate focuses

on the potential effects of needed reforms on both beneficiaries and

workers, it should also be recognized that Social Security reforms could

affect the income that workers receive from private pensions. For many

workers, the income provided through private employer-sponsored

pensions represents an important pillar of our nation’s retirement income

structure. The numerous proposals under consideration for improving the

financial status of Social Security involve a mix of options, including

reducing future benefits, raising the retirement age,2 raising revenues, and

introducing vehicles for investing payroll taxes in marketable financial

securities such as stocks and bonds. Such reforms, while directly affecting

the retirement income provided through Social Security, will also alter the

environment in which private pensions are sponsored and designed.

To better understand the implications of Social Security reform, you asked

us to study the interactions between Social Security and private pensions.

Specifically, we agreed to examine (1) the primary linkages between Social

Security and private pensions and the way they interact to provide

retirement income for workers and families, (2) the effects of traditional

Social Security reforms on the structure of employer-sponsored pension

1

Social Security refers to the Old-Age and Survivors Insurance and Disability Insurance

(OASDI) programs.

2

When Social Security was instituted, the age of eligibility for full benefits, or normal

retirement age, was set at age 65. The Congress later enacted an early retirement age of 62 at

which any worker could retire with actuarially reduced benefits. The normal retirement age

is set to gradually rise to 67 by the year 2027 while the age for first eligibility for Social

Security retirement benefits (early retirement age) remains at 62.
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plans through changes in the costs and incentives faced by employers and

workers, and (3) the effects of nontraditional reforms, such as individual

accounts, on the structure of the private pension system.

Examining the relationship and interactions between Social Security and

private pensions involves several areas of considerable complexity, and the

conflicting nature of much empirical research complicates any assessment

of the effects of Social Security reforms on private pensions. Our objective

in this study is to provide an overview of the key potential implications that

Social Security reform might have for private pensions. In conducting this

assignment, we surveyed an array of literature relevant to the topic. We

reviewed academic and policy studies of issues relevant to determining the

responses of employers and workers to Social Security reform and changes

in pension law and plan design. We supplemented this research with

interviews of pension experts. Our work was conducted between January

and August 2000 in accordance with generally accepted government

auditing standards.

Results in Brief Social Security and private pensions are key sources of retirement income

that are linked through the employer costs associated with the

compensation provided to workers. Because pension plans serve as a

supplement to Social Security, many plans are integrated; that is, they

explicitly incorporate Social Security benefits or contributions into their

plan design. Employers also implicitly consider Social Security provisions

in designing pensions that complement their human resource and other

business strategies. For example, plan provisions may be linked to Social

Security’s normal retirement age or provisions for disability benefits.

Because of these linkages, reforms in Social Security may affect worker

and employer behavior, which in turn may have consequences for pension

plan design, coverage, or benefit amounts.

Traditional reforms in the Social Security program, such as changing

benefits or taxes or raising the normal retirement age, may alter the

incentives of workers and employers, which could prompt adjustments in

private pension plans. The effect of any specific reform will depend on the

nature of the change (e.g., increase payroll taxes), its magnitude (e.g., cut

benefits by 20 percent), its time horizon for implementation (e.g., increase

payroll taxes in 2002), and its interaction with other provisions that

comprise a comprehensive reform proposal. Employers’ and workers’

responses to reform will be shaped by a variety of factors, including the

firm’s size, the type of pension plan offered, and the economic status of the
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worker. Employers will respond to reforms that affect compensation costs

or the incentives for sponsoring a plan. For example, a reduction in Social

Security benefits will raise compensation costs for employers with plans

that directly offset the earned pension benefit with a portion of the

worker’s Social Security benefit. In response, employers might redesign the

plan feature, absorb the increased cost, or shift the cost to customers

through price increases or to employees through employment or

compensation reductions, among other possible changes. In reaction to

increasing the normal retirement age for Social Security, employers could

face added pension costs for subsidizing early retirement and may redesign

their plans to raise the eligibility age for retirement benefits. Workers may

also respond to Social Security reforms that increase their contributions or

reduce expected benefits by adjusting their savings behavior—for example,

by increasing participation in 401(k) plans or accumulating more savings

through other vehicles. They might also choose to work more, retire later,

or demand higher pension compensation.

The introduction of individual accounts raises a broad set of issues for

private pensions, depending on how such a reform is structured, its scope

(whether it is voluntary or universal), and its interaction with other reforms

as part of a broader reform proposal. Like more traditional reforms, the

effects of an individual account feature on the pension system will depend

on the explicit and implicit linkages between Social Security and pensions

and employers’ and workers’ responses to specific reforms. For example,

the introduction of individual accounts could affect private pensions by

changing the way employers integrate Social Security and pension benefits.

Depending on the extent to which individual accounts affect employer

costs, workers’ reactions to risk, and workers’ ability and propensity to

save, private pension coverage and participation could increase or

decrease. The design and implementation of individual accounts will affect

employer costs and could present substantial challenges in coordinating

pension plans with individual accounts within the current regulatory

framework for pensions. At the same time, an individual account structure

could provide an opportunity for many workers to expand their access to

private securities markets and increase their ability and propensity to save

for retirement. This might be possible if, for example, a voluntary

individual account is linked to Social Security. Individual accounts could

also expand the choice and flexibility available to workers in meeting their

income needs during retirement.

Our retirement income institutions operate in a dynamic environment

where workers, employers, and policymakers interact to pursue the goal of
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retirement income security. The complexity of making policy change

suggests that any reform should be taken with careful deliberation. At the

same time, ensuring retirement income for those who most need it and

encouraging the development of new opportunities to secure and expand

the retirement income of future generations should be emphasized.

Background Social Security is the largest source of retirement income for most

American workers and their families. Since the program began paying

benefits in 1940, Social Security has served as a publicly provided source of

retirement income for workers. The program also provides benefits for

dependents, survivors, and the disabled and covers about 96 percent of all

workers. Social Security’s benefit structure is based on a formula that

replaces specified percentages of lifetime average indexed earnings. The

basic benefit formula is redistributive in that the percentage of lifetime

earnings replaced (replacement rate) is higher for lower earners than it is

for higher earners. Benefits for dependents and survivors are generally

based on the earnings record of the worker from whom benefits are

claimed. When Social Security was instituted, the age of eligibility for full

benefits, or normal retirement age, was set at age 65. The Congress later

enacted an early retirement age of 62 at which any worker could retire with

actuarially reduced benefits. The normal retirement age is set to rise

according to a phased-in schedule to age 67 by the year 2027.

Numerous Proposals

Address Social Security’s

Long-Term Solvency

Social Security is financed mainly through payroll taxes paid by workers

and employers on covered earnings up to a maximum annual earnings

level.3 The program is generally financed on a “pay-as-you-go” basis with

the payroll taxes of current workers used to pay the benefits of current

beneficiaries. Periodic surpluses of revenues over expenditures are

credited to the Social Security Trust Funds, which represent future

financial commitments by the government to the program. Current Trust

Fund projections show that projected future revenues, including the

amounts credited to the Trust Funds, will not be sufficient to finance full

benefits in the year 2037 and thereafter.

3

The maximum taxable earnings level in the year 2000 is $76,200.
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The Congress has addressed Social Security’s solvency in previous reform

efforts, notably the 1977 and 1983 Amendments to the Social Security Act.

These reforms focused on modifying the program’s existing benefit and

financing structures without introducing major changes in the program.

The reforms tended to focus on traditional options such as increasing the

payroll tax rate or covered earnings, altering the benefit formula, and

increasing the age of retirement. For example, the 1977 Amendments made

technical changes to the benefit formula, lowered benefits, and set higher

future payroll tax rates. The 1983 Amendments made a number of changes,

including advancing the payroll tax rate increases enacted in 1977,

increasing the number of workers covered under Social Security, and

enacting a gradual rise in the normal retirement age to 67, which began to

be effective this year. Despite the importance of these earlier reforms, there

is relatively little evidence regarding their effects that is directly applicable

to understanding the implications of current reform efforts on private

pensions. Part of the reason for the lack of evidence is that the effects of

Social Security reforms on pensions are intertwined with broader

economic trends and coincident changes in tax and regulatory policies.4

4

For example, major reforms of the income tax took place in 1981 and 1986. In addition, this

and other legislation enacted in the 1980s substantially increased pension regulation.
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The nature of the current reform debate changed when the 1994-1996

Social Security Advisory Council discussed a broader range of reforms.5 In

addition to debating traditional reform options, the Advisory Council

considered changing the basis for financing the program to include private

investment. One option would involve government investment of Trust

Fund assets in marketable financial securities. Another option would

create an account for each worker, who could then invest in marketable

securities. While both of these options might reduce the future cost of

Social Security to employers and workers, the individual account option

would have greater potential implications for Social Security’s benefit

structure. This report will focus on individual accounts rather than

collective investment because of the implications for the benefit structure

and because numerous proposals incorporating individual accounts with

more traditional options have been put forth to address the program’s longterm solvency.6

Role of Private Pensions

Has Evolved Over Time

Before the creation of Social Security, private pensions played a modest

role in providing retirement income. However, from 1940 to 1970, the

percentage of private wage and salary workers participating in private

pension plans increased from 15 to 45 percent due to a variety of factors,

including changes in tax and labor policies. This growth in pension

participation has slowed, however, and has stabilized since 1970 at about

one-half of the workforce.7 Historically, the pension system developed with

defined benefit pension plans as the predominant form of coverage.

Defined benefit plans generally provide benefits using a specific formula

based on the earnings and tenure of the worker. Typically, defined benefit

plans are funded completely by the employer, who bears the investment

risk of such an arrangement. The other major type of pension plan is the

5

Report of the 1994-1996 Advisory Council on Social Security, Vols. I and II (Washington,

D.C.: Advisory Council on Social Security, 1997).

6

For broad discussion of the Social Security reform debate and various proposals and

options, see Social Security: Evaluating Reform Proposals (GAO/AIMD/HEHS-00-29, Nov. 4,

1999), and Social Security: Different Approaches for Addressing Program Solvency

(GAO/HEHS-98-33, July 22, 1998). For discussion of the collective investment option, see

Social Security Financing: Implications of Government Stock Investing for the Trust Fund,

the Federal Budget, and the Economy (GAO/AIMD/HEHS-98-74, Apr. 22, 1998).

7

There are different surveys of pension plan participants and different ways to measure

pension coverage. Using Current Population Survey data, about 47 percent of the employed

labor force is currently covered by a pension plan. Pension Plans: Characteristics of Persons

in the Labor Force Without Pension Coverage (GAO/HEHS-00-131, Aug. 30, 2000).
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defined contribution plan, which generally involves contributions by the

employer to an individual account held for the worker, with the worker

bearing the investment risk. Some defined contribution plans are

structured to allow contributions by the employee. Often, defined

contribution plans are provided by employers as a supplement to defined

benefit plans.

The current framework of the private pension system was shaped largely

by the Employee Retirement Income Security Act (ERISA) of 1974. ERISA

imposed specific requirements for vestingthat is, the years of service

after which participants are entitled to benefitsand set other minimum

requirements to protect pension promises and workers’ benefits. It

established guidelines for the operation and funding of pension plans.

ERISA also required plan termination insurance to protect workers’

benefits under private sector defined benefit pension plans. In part to

encourage plan sponsorship, pension plans have long been accorded

favorable income tax treatment under the tax code. Employer

contributions to pension funds, up to certain limits, are deductible

expenses, and employee contributions and the contributions’ investment

earnings are deferred from taxation. The 1980s saw the institution of

certain employee deferral defined contribution arrangements under section

401(k) of the Tax Code, which generally allow tax-deferred worker

contributions in addition to employer contributions.8 The growth of 401(k)

plans has been cited by experts as a major factor underlying the recent

trend toward the greater availability of defined contribution plans, in

addition to other factors, such as the increased costs of defined benefit

plans partly associated with increased regulation and changes in income

tax laws, which reduced the tax advantages of pensions.

Social Security and

Pensions Are Key Sources

of Retirement Income

Social Security provides about 38 percent of the aggregate cash income of

the elderly (see fig. 1). Private pensions are a voluntary, employer-provided

source of retirement income that comprises about 10 percent of aggregate

elderly income.9 Also, some pensions are provided by public employers

8

The Revenue Act of 1978 added Section 401(k) to the Tax Code. However, the regulations

implementing this section were not proposed until 1981 and final regulations were approved

in 1988.

9

This category may include individual annuities and may not include the liquidation of

savings (and interest) that originate as pension lump sums.
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such as federal, state, and local governments. These comprise about 8

percent of aggregate elderly income.

Figure 1: Percentage Share of Aggregate Cash Income by Retirement Income

Source, Married Couples and Unmarried Individuals, Age 65 and Older, 1998

Source: Income of the Population, 55 or Older, 1998, Social Security Administration, Washington, D.C.,

Table VII.3, p. 121.

Social Security

Other

Pensions

Income from

Assets

Earnings

37.6

3.6

18.2

19.9

20.7

Government

Employee Pensions 8.4

Private Pensions

or Annuities 9.8
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Pensions generally supplement Social Security benefits. For all but the

lowest and highest income quintiles, pensions are the second most

important source of retirement income (see fig. 2). In contrast, the benefits

provided by Social Security are most important to workers and households

in the middle ranges of the income distribution. Social Security comprises

over 80 percent of the retirement income for households in the first

(lowest) and second quintiles of the distribution. For the third (middle) and

fourth quintiles, Social Security still serves as the most important source of

retirement income. For the highest quintile, pensions are a more significant

source of retirement income than is Social Security (20.5 percent compared

with 18.3 percent), but pensions represent a smaller share for this group

than either personal savings or earnings. One factor underlying these data

is that pensions are not a universal source of retirement income as is Social

Security. As of 1999, about half of the working population was covered by a

pension. Although a larger number of workers may obtain some pension

coverage over an entire career,10 it is unlikely that pension coverage will

ever match the nearly universal coverage provided by Social Security.

10One effort to project future pension recipiency estimated that by 2018 about three-fourths

of households would receive some income from pensions. Employee Benefit Research

Institute, EBRI Databook on Employee Benefits, 3rd ed. (Washington, D.C., EBRI, 1995).
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Figure 2: Retirement Income by Source and Income Quintile, Households Age 65 and Older, 1998

Note: The data presented here show pension income provided by both public and private employersponsored pensions. These two sources display largely the same pattern across income quintiles.

Source: GAO computations based on data in Income of the Population, 55 or Older, 1998, Social

Security Administration, Washington, D.C., Table VII.5, p. 123.

Linkages Between

Social Security and

Private Pensions Are

Explicit and Implicit

Social Security and private pensions are key sources of retirement income

that are linked through the employer costs associated with the

compensation provided to workers. Employers consider Social Security

provisions in designing pensions that complement their human resource

and other business strategies. Some of the interactions between Social

Security and pensions are explicit, insofar as pension laws and regulations

Income Level (Quintile)

0

10,000

20,000

30,000

40,000

50,000

60,000

Savings/Earnings/Other

Pensions

Social Security

First Second Third Fourth Fifth

Elderly Household Income (Dollars)
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permit employers to formally “integrate” or take account of Social Security

benefits and contributions in designing their pension plans. In addition,

many pension plans may be indirectly or implicitly linked with other Social

Security features, such as the normal retirement age or eligibility criteria

for disability benefits.

Pensions Are Designed to

Address Employer Needs

and Foster Adequate

Income Replacement for

Workers

Many employers choose to offer a pension plan to further their business

strategies or objectives. Although employers are motivated to offer a

pension plan for many reasons,11 the most important involve (1) the

employer’s need to attract and retain a workforce in a competitive labor

market and (2) the tax advantages, or preferences, associated with

pensions. The employer’s pension plan decision also will be shaped by the

nature and characteristics of the workforce available to the employer and

the employer’s size and type of industry. These factors will enter into the

decision about the type of plan the employer will choose to sponsor and the

benefits it provides to individuals at different income levels.

Employers typically want to attract workers based on their productivity,

motivate them to perform efficiently in pursuit of the firm’s goals, and

retain them to reduce the costs associated with turnover. Pensions provide

a tool for accomplishing these objectives. For example, pensions are a

means of providing deferred compensation that may encourage workers to

make long-term commitments to employers. This may have the benefit of

reducing turnover, making for a more stable, productive workforce.12 At the

same time, employers also want to manage the retirement of their

workforce, and pensions are a means of offering incentives for workers to

retire immediately or sooner or later than they would otherwise.

Employers also choose to sponsor pension plans because of the favorable

federal tax treatment of pension contributions and asset returns. This

11For a more detailed discussion, see Alan L. Gustman, Olivia S. Mitchell, and Thomas L.

Steinmeier, “The Role of Pensions in the Labor Market: A Survey of the Literature,”

Industrial and Labor Relations Review, Vol. 47, No. 3, Apr. 1994, pp. 417-38.

12A related rationale is that pensions provide a higher level of compensation that encourages

workers to exert greater effort on the job. It may be difficult to monitor employee

performance (i.e., detect low effort) in certain occupations. The higher total compensation

offered through a pension imposes a potentially significant loss or penalty on the worker in

the event that low effort by the worker is detected. Thus, pensions help overcome

monitoring problems and ensure employee effort. This may be particularly important for

professional and managerial occupations.
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favorable tax treatment lowers the cost of a dollar of pension

compensation to workers relative to an additional dollar of cash earnings.

Business owners and more highly paid employees find this tax treatment

attractive. Also, the tax advantages of pensions have traditionally played a

role in the financial management of the corporation, allowing firms some

flexibility in minimizing their tax liability and funding plans less

expensively. For example, a firm may contribute, subject to certain

conditions and limitations, more to the plan during profitable years, thus

lowering its tax liability, and less during times when profitability is poor.

In addition to motivations involving the labor market or tax preferences,

workforce characteristics and other business-related factors enter into an

employer’s decision to sponsor a plan and the form that plan takes. For

example, the workforce characteristics of a small employer may differ

from those of a large employer. Small employers may tend to employ

workers for whom nonwage compensation is less important than wages.

Such workers may be younger, less experienced, lower paid, and exhibit

higher turnover and less attachment to full-time work than do workers in

larger firms. An employer’s industry and occupational structure are also a

consideration. Firms that use highly skilled labor may be more motivated

to sponsor pensions than those using less skilled labor.

After deciding to sponsor a plan, employers must determine the design of

the plan and the benefits to be provided for workers. One of the most basic

decisions is whether the plan is based on a defined benefit or a defined

contribution, a decision that determines whether the employer or the

worker bears the investment risk associated with funding the plan.

Employers, in designing plans and setting benefit levels, will also consider

a variety of factors, including the total retirement income that is considered

adequate.13 One common measure of retirement income adequacy is the

replacement rate, which represents the benefit amount in retirement for a

single worker or household in relation to a measure of pre-retirement

earnings, such as earnings in the year before retirement. Currently, many

benefit professionals consider a 70 to 80 percent replacement rate as

adequate to preserve the pre-retirement living standard.14 Social Security

and pensions play complementary roles in helping workers attain an

adequate retirement income. Because the Social Security benefit level

provides a proportionately higher benefit for earners at lower levels of the

13Dan M. McGill, et al., Fundamentals of Private Pensions, 7th ed. (Philadelphia, Penn.:

University of Pennsylvania Press, 1996).
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distribution,15 some employers may balance this feature by designing plans

to provide proportionately higher benefits to middle and higher income

workers. 16

Social Security and

Pensions Are Explicitly

Linked Through Integration

Provisions

Social Security reform could affect the employer’s pension plan decisions

in cases where Social Security is explicitly linked to the pension plan’s

provisions. One way that Social Security and pensions are explicitly related

is through the “integration” or the consideration of Social Security benefits

or contributions in calculating a private pension benefit. The concept of

integration relates to the employers’ responsibility to provide Social

Security contributions on behalf of workers and receive credit for these

contributions in relation to their contributions or the benefits provided

under their pension plans. In defined benefit plans, integration pertains to

the benefits paid to participants; in defined contribution plans, it relates to

the contributions made on behalf of workers by employers. Defined benefit

plans commonly involve two methods of integration:

14The standard that pension professionals consider an adequate replacement rate has

changed over the years. While a 50 percent replacement rate might have been considered

adequate in the 1930s, when Social Security was instituted, this standard has risen. See

Sylvester J. Schieber, “The Employee Retirement Income Security Act: Motivations,

Provisions, and Implications for Retirement Income Security,” paper presented at “ERISA

After 25 Years: A Framework for Evaluating Pension Reform,” Washington, D.C., Sept. 17,

1999, pp. 8-9. Also note that the replacement rate considered to be adequate can be

computed in a more sophisticated way, netting out Social Security taxes, other taxes, or

working expenses that will not be paid in retirement. Thus, desired or target replacement

rates can vary significantly by income level and other factors. See Bruce A. Palmer,

“Retirement Income Replacement Ratios: An Update,” Benefits Quarterly, 2nd Quarter, 1994.

15Social Security currently provides a replacement rate of 53 percent for a low earner, 39

percent for an average earner, and 24 percent for a maximum earner. These figures are

based on applying Social Security benefit rules to hypothetical retired workers who had

various specified (steady) earning levels over their careers and attained age 65 in 2000. The

average earner represents a worker who earned the average of covered workers under

Social Security each year. The low earner earns 45 percent of this average. The maximum

earner has annual earnings equal to the OASDI contribution and benefit base each year.

16Pension plan design is influenced by an array of other factors, such as pension regulation,

which may counteract design features that benefit higher earners. For example, available

data suggest that typical pension replacement rates for a 30-year career worker have been in

the 20- to 40-percent range across the earnings distribution and that lower earners received

slightly higher replacement rates than higher earners. Olivia S. Mitchell, “New Trends in

Pension Benefit and Retirement Provisions,” Working Paper No. 7381 (Cambridge, Mass.:

National Bureau of Economic Research, Oct. 1999).
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• In the offset method, the employer designs the plan to provide a given

benefit based on the employee’s total compensation. A percentage of

any Social Security benefit received is then deducted from the

calculated pension benefit.

• In the excess or step-rate method, one layer of benefits is generally

based on the employee’s total compensation, and a second layer is based

on compensation in excess of a specified dollar level termed the

“integration level.” This method is analogous to the way defined

contribution plans are integrated with Social Security on the basis of

contributions.17

Explicit integration provisions remain a common feature of many pension

plans even though their form has changed over time. The Congress

substantially revised integration provisions in the Tax Reform Act of 1986,

and there was a subsequent decline in the prevalence of integrated plans

and a strong shift toward the use of the excess method. From 1986 to 1997,

the percentage of all defined benefit plan participants in medium to large

firms with an integrated plan declined from 62 to 49 percent. Moreover, the

percentage of participants in defined benefit plans using the offset method

declined from about 43 to 13 percent of all participants, while the

percentage of participants in plans using the excess method increased from

24 to 36 percent (see fig. 3).18

17For example, in a defined contribution plan, a “base contribution percentage” is applied to

compensation below the integration level. For compensation above the integration level, a

higher or “excess contribution percentage” is applied. The difference between these two

contribution percentages is commonly referred to as the “permitted disparity.” This

difference is limited to either 5.7 percentage points or the base contribution percentage. In

other words, it cannot exceed 5.7 percent (see McGill, Fundamentals of Private Pensions,

Ch. 15). To have a plan design that relies on permitted disparity under Sec. 401(l) of the Tax

Code, a plan must satisfy certain criteria called “safe harbors” under nondiscrimination

rules, which seek to promote equity in the provision of pension benefits. In addition, the

“integration level” to which permitted disparity applies is often the maximum taxable ceiling

on covered earning under Social Security. The integration level may be lower than this

ceiling but may not exceed it, and different permitted disparity rules apply. Pension benefits

and contributions can be integrated with Social Security outside the permitted disparity

rules as long as the plan meets the general nondiscrimination provisions of the Tax Code.

18For information on the characteristics of individuals in integrated pension plans, see Keith

A. Bender, “Characteristics of Individuals with Integrated Pensions,” Social Security

Bulletin, Vol. 62, No. 3, 1999, pp. 28-40.
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Figure 3: Integration With Social Security in Defined Benefit Plans, Percentage of Full-Time Participants, 1980-1997

Source: U.S. Department of Labor, Bureau of Labor Statistics, “Employee Benefits in Medium and

Large Firms, 1980-97.”

Pensions Are Implicitly

Linked in Various Ways With

Social Security

Because Social Security has a central role in providing retirement income,

almost all pension plans are implicitly linked to Social Security, insofar as

their design takes into account the provisions of and benefits provided by

Social Security. Because pension designs have evolved over time, they have

incorporated specific features related to Social Security. Examples of such

implicit linkage involve the specification of the age of benefit eligibility

(retirement age) and benefit provisions for survivors and the disabled.

Year

0

10

20

30

40

50

60

70

1980 1981 1982 1983 1984 1985 1986 1988 1989 1991 1993 1995 1997

Percentage of Full-Time Participants

With Integrated Formula

Offset Method

Excess Method
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An important implicit linkage with Social Security is pension plans’

specification of a normal retirement age. The retirement ages provided by

Social Security form a basic framework around which plans design their

provisions. Private defined benefit pensions generally include age and

service provisions that determine when an employee becomes eligible for

benefits. While some plans have age-only or service-only retirement

requirements, most plans base retirement benefit eligibility on a

combination of age and service.19 These age and service provisions allow

employers to structure plans in ways that allow eligible workers to retire

earlier than the ages set by Social Security. However, most plans allow

workers who meet minimum service (vesting) requirements to claim

pension benefits by age 62 or age 65. Another example of an implicit

linkage with Social Security occurs when plans provide “bridge benefits,”

which provide workers who retire from a private pension a supplement

until the worker is eligible for a Social Security benefit at age 62.20

Social Security and pensions are also implicitly linked through provisions

concerning survivor and disability benefits. Employer-sponsored pension

plans offer benefits for surviving spouses of retired workers, referred to as

joint and survivor benefits.21 Some pension plans also provide disability

benefits. Joint and survivor benefits are provided in addition to the survivor

benefits received under Social Security. Private disability benefits often

supplement Social Security disability benefits. In 1995, more than 60

percent of full-time employees were covered under long-term disability

plans. Although not required by law, many plans calculate the private

disability benefit by offsetting the amount received from Social Security

disability benefits in a manner somewhat analogous to the integration of

pension benefits with Social Security old age benefits.

19Mitchell, “New Trends in Pension Benefit and Retirement Provisions.”

20Janice Gregory, “Possible Employer Responses to Social Security Reform,” in Prospects

for Social Security Reform, edited by O. Mitchell, R. J. Myers, and H. Young (Philadelphia,

Penn.: University of Pennsylvania Press, 1997), pp. 311-32.

21Defined benefit plans are required to provide a 50 percent joint and survivor annuity as a

benefit distribution option to a married employee. Under defined contribution plans, the

surviving spouse inherits the married employee’s account balance. See ERISA Industry

Committee (ERIC), The Vital Connection: An Analysis of the Impact of Social Security

Reform on Employer-Sponsored Retirement Plans (Washington D.C.: ERISA, July 1998).
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Traditional Social

Security Reforms

Could Affect Pension

Plans by Changing the

Incentives Facing

Employers and

Workers

Traditional reform options, such as reducing benefits or increasing payroll

taxes, will likely affect the provision of employer-sponsored pensions. The

effects on pensions will depend on the nature (e.g., benefit cut or payroll

tax increase), magnitude (e.g., cut benefits 10 percent or raise payroll taxes

5 percent), and timing (e.g., raise taxes or the retirement age immediately

or in 2015) of the reforms. Effects will also depend on whether Social

Security and pensions are explicitly linked, such as through integration

provisions, or implicitly linked. For any of the reforms under consideration,

the ultimate effects on pensions will depend on employers’ and workers’

responses. Employers will likely respond to reforms that change their

compensation costs or reasons for sponsoring plans. For example, Social

Security reforms that reduce benefits could raise plan costs for employers

with “offset” integration features, or employers could redesign their plans

to eliminate that feature, absorb the costs, or take other actions. Workers

will likely respond to reforms that change their Social Security

contributions, their expected benefits, or their incentives to save, work, or

retire. The interactions between workers and employers in response to

Social Security reform will determine the form that pensions take and may

affect other sources of retirement income.

Traditional Social Security

Reforms Will Affect

Integrated Pension Plans

Social Security reform proposals that incorporate traditional options such

as reducing benefits or increasing payroll taxes will directly affect private

pension plans that are integrated with Social Security. Benefit reductions

could raise compensation costs for employers with plans integrated by

using the offset method. Payroll tax increases implemented by changing

the maximum taxable earnings level could affect the incentives present in

plans using the excess method of integration. Such changes could cause

employers to consider redesigning their plans to eliminate integration

features, but they might also consider supplementing benefits to employees

at higher earning levels through nontax-qualified plans.

Reform proposals that reduce benefits will most likely increase employer

costs for plans using the offset integration method. Defined benefit plans

that use the offset integration method generally reduce the accrued

pension benefit by a portion of the benefit earned from Social Security.

Thus, reform proposals that reduce benefits will automatically reduce the

offset amount. As a result, the portion of the total pension benefit that will

be provided by the pension will increase, thus increasing employer plan

costs. A reduction in Social Security benefits only raises the required

pension portion by the amount of the partial offset. For offset plan
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participants, a Social Security benefit reduction may still result in a

reduction in the overall retirement income amount because the Social

Security benefit reduction is only partially offset by an increase in the

amount coming from the pension.

Employers may respond to these changes in a variety of ways. For

example, their responses could vary from modifying the offset provision to

absorbing the cost, presumably in reduced profitability, or by shifting the

cost through increased product prices or reduced employment.

Alternatively, the employer could alter other forms of compensation, such

as wage rates or health benefits, in addition to, or in lieu of, changing the

pension plan. One factor that would mitigate the overall effect of higher

employer costs in offset plans is that the prevalence of this method of

integration in defined benefit plans has declined substantially since the Tax

Reform Act of 1986 (see fig. 3). However, increasing the costs of using this

method could reduce its prevalence even further.

Social Security reform proposals that increase revenues by increasing the

taxable wage base could affect pension plans that are integrated with

Social Security using the excess method. This could reduce plan costs but

could also erode the effectiveness of the provision. This is because the

excess method permits pension plans to have a higher contribution or

accrual rate for employees above the “integration level,” which in most

such plans is the maximum taxable ceiling on earnings covered by Social

Security.22 As a result, if the level of maximum taxable earnings is raised,

employers might adjust upwards the integration level of plans, thus

reducing the number of covered workers eligible for higher contributions

or accruals. This could reduce employer costs but could make the plan a

less attractive incentive device both for the higher-earning employee and

the employer interested in providing higher compensation for certain

employees.23 Plans might be restructured with implications for benefit

amounts, and some employers might reevaluate their motivations for plan

sponsorship. One possible scenario is that employers might redesign their

22In general, the integration level may be less than, but may not exceed, the maximum

taxable earnings level. Bureau of Labor Statistics data show that for employees of medium

and large establishments in defined benefit plans using the excess method of integration,

over 90 percent are in plans that have a Social Security breakpoint as the integration level.

23Even nonintegrated plans may use the maximum taxable earnings level as a basis for the

use of permitted disparity in complying with the nondiscrimination rules of the tax code.

Changing the maximum taxable earnings level might thus alter the balance between groups

of workers that are highly compensated and those that are not.
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plans to provide more equal accruals across the earnings distribution and

then supplement the benefits of their highly paid employees through the

use of nontax-qualified plans, which is a current trend in the pension field.24

Such a development could result in lower benefits for lower and middle

earners and could make higher earners and employers less interested in

maintaining qualified pension plans.

Traditional Social Security

Reforms Will Also Affect

Pensions Through Other

Implicit Linkages

Traditional Social Security reforms will also have implications for private

pensions through implicit linkages between Social Security and pensions.

Two implicit linkages involve increases in Social Security ages for normal

and early retirement and increases in payroll tax rates. Proposals to raise

Social Security’s retirement ages and payroll tax rates could increase

employer costs, with employers possibly responding by reevaluating their

plan designs. Although little evidence on the effects of changes in the

retirement age is available, increases in the retirement age would likely

lead employers to review existing early retirement incentives in light of

current labor market conditions and their long-term human resource

objectives.

Many employers have used defined benefit pensions as a tool for workforce

management, especially in reducing turnover or encouraging early

retirement. The ability to offer early retirement incentives through a

pension allows employers to choose when to induce turnover if the firm

views this goal as beneficial. Employers can then hire newer workers at

lower compensation levels, or they can motivate midcareer employees with

greater opportunities for advancement. Data suggest that plans with ageonly retirement provisions tend to peg these provisions more closely to the

Social Security age for normal retirement (65) and around 55 for early

retirement.25 However, more typically, plans have age and service

requirements; over time these have tended toward age 62 as the normal

24Janice Gregory, “Possible Employer Responses to Social Security Reform,” p. 318; and

Christopher Bone, “An Actuarial Perspective on How Social Security Reform Could

Influence Employer-Sponsored Pensions,” in Prospects for Social Security Reform, edited

by O. Mitchell, R. J. Myers, and H. Young (Philadelphia, Penn.: University of Pennsylvania

Press, 1997), pp. 340-41. For information on nontax-qualified deferred compensation

arrangements, see Compensation Resource Group, Inc., Executive Benefits: A Survey of

Current Trends, 1999 Survey Results (Pasadena, Calif.: CRG, 1999).

25Mitchell, “New Trends in Pension Benefit and Retirement Provisions,” p. 12.
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retirement age, with provisions allowing earlier retirement, such as at age

55.

If Social Security retirement ages are raised, it is unclear whether or how

employers might adjust retirement ages in private pensions. For example,

while the 1983 Amendments enacted an increase in the retirement age that

has begun to be phased in, little is known about how this has affected the

retirement ages used in pensions. Employers will likely continue to

determine pension retirement ages according to their workforce

management objectives. One factor that may induce employers to adjust

the retirement ages of pensions is when plans offer some form of “bridge

benefit,” which provides a pension benefit supplement to early retirees

until they become eligible for Social Security retirement at early or normal

ages. In such cases, higher Social Security retirement ages with no

compensating adjustment in the plan’s retirement age could result in

substantially higher pension costs to the employer. This could create an

incentive to change the plan’s provisions for retirement age toward any

higher Social Security retirement ages or to make other plan changes.

Raising Social Security retirement ages could potentially create a larger gap

between Social Security and private pension retirement age provisions and

cause employers to rethink their retirement incentives in the context of

current labor market trends. Some evidence indicates that employers might

respond by seeking to retain the effectiveness of their retirement

incentives.26 Although some employers will want to continue to use

pensions as a tool to reduce or adjust the composition of their workforces,

recent evidence indicates that some employers may now want to retain

26One study of pension plans covering 1960 through 1980 reported evidence of an

association between retirement incentives in private pensions and retirement incentives

embedded in the Social Security benefit structure. The researchers noted that this evidence

is consistent with the hypothesis that employers offset Social Security incentives to retire

early by increasing pension incentives to delay retirement. In spite of the strong relationship

reported, the authors found no statistically significant relationship between Social Security

and changes in pension rewards for deferring retirement between ages 62 and 65. They

found that Social Security incentives for retiring at or after age 65 were typically reinforced

by similar incentives in private pension plans. See Rebecca A. Luzadis and Olivia S. Mitchell,

“Explaining Pension Dynamics,” The Journal of Human Resources, Vol. 26, No. 4 (1991), pp.

679-703.
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older workers.27 For example, some firms have been developing pension

structures in which workers accumulate benefits more evenly over their

careers, in contrast to the “back-loading” typical of traditional defined

benefit plans.28 The introduction of “hybrid” arrangements such as “cash

balance plans”29 could have the effect of reducing early retirement

subsidies found in traditional defined benefit plans and could make it more

attractive for firms to retain older workers in the future.30 Thus, to the

extent that employers are implementing pension plan provisions that

encourage workers to retire later, the potential effects of raising the Social

Security retirement age on private pensions may be mitigated.

In contrast, defined contribution plans do not have the same incentive

properties for early retirement found in many defined benefit plans.31

Defined contribution plans generally allow workers to withdraw their

accumulations or benefits as a lump-sum, without penalty, beginning at age

591⁄2. Thus, changing Social Security retirement ages may have implications

27Mitchell notes an example of a pension requirement that may have discouraged firms from

hiring older workers. Before the 1986 Omnibus Reconciliation Act (OBRA86), plans could

impose participation limits on (older) workers who joined the firm within 5 years of the

plan’s normal retirement age. Such provisions limited the pension accruals for these

workers and made it less expensive for the firm to hire them. OBRA86 eliminated maximum

age restrictions on workers, thus making it more expensive for firms to hire older workers.

See Mitchell, “New Trends in Pension Benefit and Retirement Provisions,” p. 10.

28Watson Wyatt Worldwide, The Unfolding of a Predictable Surprise: A Comprehensive

Analysis of the Shift From Traditional to Hybrid Plans (Bethesda, Md.: Watson Wyatt

Worldwide, 2000).

29Hybrid pension plans combine features of defined benefit and defined contribution plans.

For example, cash balance plans have a benefit structure that looks similar to a defined

contribution plan in that benefits are expressed as a lump-sum individual account balance.

However, cash balance plans (which legally remain defined benefit plans) operate like

defined benefit plans in that the employer bears the investment risk to meet a given return

on the account.

30Robert L. Clark and Sylvester J. Schieber, “Taking the Subsidy Out of Early Retirement:

The Story Behind the Conversion to Hybrid Pensions,” paper prepared for the Conference

on Financial Innovations for Retirement Income, The Wharton School, University of

Pennsylvania, Philadelphia, Penn., May 1-2, 2000.

31Defined contribution arrangements typically have a more even distribution of accruals

over time than typical defined benefit plans. One expert suggests that the attractiveness of

defined benefit plans as a workforce management tool may have declined relative to defined

contribution arrangements. Richard A. Ippolito, “The New Pension Economics: Defined

Contribution Plans and Sorting,” The Future of Private Retirement Plans (Washington, D.C.:

EBRI, 2000).
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for the age at which individual workers choose to take their benefits. It is

likely that some workers would delay retirement as they try to meet

retirement income goals.

Raising payroll taxes could lead employers to reduce plan benefits or even

terminate some plans, which could reduce worker pension coverage.

Higher payroll taxes would directly raise the compensation costs of

employers in the short term and would likely trigger a series of economic

adjustments to wages, prices, or employment.32 Pensions or other elements

of compensation, such as health benefits or wages, could be reduced,

leaving workers’ overall compensation and the firm’s profitability

unchanged. Employer responses such as reducing plan benefits or

terminating a plan could depend in part on the size of the firm. Because

smaller employers are generally more sensitive to changes in their

compensation costs, payroll tax increases could make them more likely to

terminate their plans, compared with larger firms. If this is the case, then

overall pension coverage might show a modest decrease, and the existing

disparity in coverage and compensation between large and small firms

might be exacerbated. In general, even though payroll taxes have been

increased in the past, it is difficult to disentangle the effects of payroll taxes

on employers and pensions from other influences.

Workers May Respond to

Traditional Social Security

Reforms That Affect

Contributions or Future

Benefits

A key element in evaluating the effect of traditional Social Security reforms

on pensions involves workers’ responses to such reforms. While employers

play a primary role concerning the decision to sponsor and design a

pension plan, worker demands can play a substantive role in influencing

these decisions. In addition, workers make individual decisions that have

implications for their future retirement income. These include decisions

about consumption and saving, how much to work, and when to retire.

Social Security reform could affect the private pension system through its

effect on workers’ saving and consumption decisions. Most traditional

reforms involve workers paying more for promised future benefits or

accepting lower benefits. Workers could experience either a reduction in

their current income available for consumptionif payroll taxes are

32It has long been argued that employers do not bear any direct burden of the payroll tax

because it is “passed on” to workers through these economic adjustments. Even if this

conclusion is accepted, pensions might be affected because they constitute a way in which

the economic adjustments could be implemented. There has been examination of the effects

of changes in the Social Security payroll tax generally, but for the most part, this literature is

inconclusive with regard to the effects on employers and pensions.
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increased, for exampleor a lower anticipated retirement income, which

would occur if benefit levels were reduced.

Workers’ response to traditional Social Security reforms could take

different forms. They might act to offset the effect of reforms by saving

more, or working more and retiring later. Alternatively, they might not

change their savings or employment levels but experience a reduced living

standard or draw down other assets. If Social Security reform reduces

anticipated retirement income, many analysts would expect that workers

might, to some degree, want to offset this effect by increasing their saving

outside the Social Security program. Workers could demand higher pension

compensation or save individually by contributing to 401(k)s or individual

retirement accounts (IRAs).33 Past research has considered whether the

existence of Social Security and workers’ anticipation of future benefits

reduced their savings in other assets. While some analysts found evidence

of reduced saving, others disputed such an effect.34 More recent research

has examined whether the creation of IRAs or 401(k)s has led to a net

increase in individual saving. Some economists contend that the

contributions to these savings vehicles are offset by a reduction in other

forms of saving, while others find that contributions are not completely

offset and hence yield a net increase in savings by workers.35 The

conflicting nature of these empirical debates illustrates the difficulty in

drawing conclusions about the effects of proposed Social Security reforms

on private pensions or national saving overall.

Another related area in which Social Security reform could have

implications for private pensions concerns workers’ decisions about how

much to work and when to retire. Some analysts believe that if workers

perceive a current or future decrease in income due to lower future

benefits or higher payroll taxes, most would work more to make up for

lower anticipated income. These reactions can also apply to their choice of

retirement age. Workers anticipating less retirement income may choose to

33This could also prompt calls for raising limits on allowable pension contributions or

benefits.

34For a summary of this empirical debate, see Henry Aaron, Economic Effects of Social

Security (Washington, D.C.: The Brookings Institution, 1982).

35For a recent summary and contribution to this debate, see William Gale, “The Impact of

Pensions and 401(k)s on Saving: A Critical Assessment of the State of the Literature,” paper

presented at “ERISA After 25 Years: A Framework for Evaluating Pension Reform,”

Washington, D.C., Sept. 17, 1999.
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stay in the workforce longer than they might otherwise. Thus, benefit cuts

or tax increases may create incentives for workers to work more in the

current period or work more years to offset the effect of these changes.

Such effects could imply that over time workers might tend toward higher

labor force participation, more hours of work, or delayed or phased-in

retirement. In turn, employers may redesign pensions to address such

worker preferences. The movement toward defined contribution plan

designs, which tend to reduce early retirement incentives, may be a trend

consistent with these effects.

Structural Reforms to

Social Security Could

Have Implications for

the Private Pension

System

Including individual accounts as a reform feature raises key issues for the

private pension system. Implications for the private pension system will

depend on how the individual account is structured (e.g., how it is financed

and administered), its scope (e.g., whether it has voluntary or universal

participation), and its interaction with other reform provisions (e.g.,

whether other benefits are reduced). Like more traditional reforms, the

effects of an individual account reform feature on the pension system will

occur through explicit and implicit linkages between Social Security and

pensions and employer and worker responses to specific reforms. Because

individual accounts have generally been proposed as a part of more

comprehensive reform packages that include traditional reforms such as

cutting benefits, it is difficult to disentangle their possible effects on private

pensions.

Proposals for Individual

Accounts Vary in Form and

Raise Many Issues

The implications of individual accounts for the private pension system will

depend on how the accounts are structured and administered. 36 These

issues include the magnitude and nature of the accounts’ funding, how the

accounts are administered, whether participation is voluntary or universal,

the degree of choice and control accorded to workers in regard to

investment of account funds and the form in which benefits are received,

and the interaction of individual account features with other reform

provisions.

The most basic structural issues concern the magnitude of the accounts’

financingthat is, the amount or the percentage of payroll devoted to the

36Social Security Reform: Implementation Issues for Individual Accounts (GAO/HEHS-99-

122, June 18, 1999).
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accountand the nature of that financing. While proposals vary, a number

of them focus on creating accounts with a contribution of 2 percent of

Social Security taxable payroll. This feature determines the future role

accounts will play in Social Security financing and whether investment

returns might alleviate the need for traditional reforms. The amount

devoted to the account will also determine workers’ retirement income,

contingent on investment performance.

The nature of the individual accounts’ financing also has implications for

the private pension system to the extent that it affects the contributions

employers make on behalf of workers. Some proposals implement

individual accounts through a “carve-out,” which generally maintains the

current level of payroll tax rates but devotes a portion of payroll taxes (e.g.,

2 percent) to the individual account. Other proposals implement the

individual accounts by means of an “add-on,” which generally creates

accounts that supplement the current Social Security program and

increases overall contributions to the system. In general, while add-on

accounts would appear more likely to directly increase employers’ costs,

assessing the implications of these different structures for private pensions

is complicated because it is necessary to consider the entire reform

package, which may include benefit cuts or other revenue measures such

as general revenue financing or government borrowing. Also, the degree to

which Social Security benefits are reduced or offset against the account is

an important design issue.37 The accounts can be integrated into the Social

Security benefit structure in a way that preserves all currently legislated

benefits as a floor. This would limit the risk borne by the worker, while

allowing the worker to share in the rewards if the account exceeds the

returns implicit in the current Social Security benefit structure. This

feature will also affect the overall cost of a Social Security reform package

to workers and employers.

Another key issue concerns whether the accounts would be structured to

allow workers to hold the account entirely outside the Social Security

program or whether the accounts would be set up through government

institutions that would play a role in administering and channeling funds to

investors. Employers are concerned about the resources and

administrative costs they would have to devote to managing the accounts

and financial flows. Proposals differ in the degree to which the

37Proposals that include this feature are discussed in Social Security: Evaluating Reform

Proposals (GAO/AIMD/HEHS-00-29).
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administration of the accounts is either centralized through government

institutions or decentralized through employers and the financial industry.

Some believe that retaining some government role could reduce

administrative burdens on employers and workers, but others emphasize

the advantages of expanded choice that could be made available to

workers.

The scope of an individual account reformthat is, whether the account is

mandatory or voluntaryalso could have implications for the private

pension system. Some proposals include mandatory account provisions

because they would appear to be more directly linked to Social Security,

and in particular, to the universal nature of the program.38 Mandatory

accounts thus provide a degree of certainty about the structure of Social

Security that employers can take into account in responding to reform and

in possibly redesigning their plans. The linkage between voluntary

accounts and Social Security would appear to be more tenuous and more

complicated to analyze. For example, some voluntary account designs are

structured to supplement Social Security and would be hard to distinguish

from retirement saving vehicles such as IRAs. Such similarities could result

in low participation and minimal impact on most workers’ retirement

income and on pension plans generally. Alternatively, voluntary accounts

could be targeted to specific groups, such as young workers, lower income

workers, or those who are not currently covered by a private pension. Such

designs could address some of the concerns about the adequacy of benefits

and gaps in coverage.39

Another important individual account design feature concerns the degree

of choice and control that workers would have over their funds and the

degree of flexibility that workers might have in accessing the funds in their

accounts. Providing workers more options in which to invest their funds

allows them to diversify risk and perhaps earn higher returns. However,

this can increase the costs of the system. Allowing greater flexibility in

accessing funds could give workers greater control over the decision to

38There are different rationales for the mandatory and universal nature of Social Security.

One rationale is that a government program can more easily deal with adverse selection in

providing annuities compared with the private sector. Another rationale involves protection

against those who would “free ride” on government support unless required to participate

and contribute.

39Note that, depending on which workers contribute to Social Security individual accounts

and the way in which contributions are treated, the ability of existing pension plans (such as

401(k)s) to pass nondiscrimination tests could be affected.
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retire. They could also have greater control over the form in which they

receive their retirement income over their lifetime because they could

choose annuities or keep a portion of their funds invested. However,

allowing greater access to funds before retirement and greater choice in

the form in which retirement income is received could complicate

administration, increase costs, and possibly reduce future retirement

income.40

The interaction of an individual account feature with the other provisions

of a comprehensive reform also has consequences for the private pension

system. In this instance, the net effects on the private pension system

would depend on the other provisions included in the reform and the

structure of the individual account feature. Individual accounts could

either moderate or exacerbate these effects, depending on the exact

features of the broader reform.

Individual Accounts Could

Have Broad Implications for

Integrated Plans and

Employer-Worker Decisions

Structural reforms that create individual accounts could have an array of

implications for private pensions. Some arise from the explicit and implicit

linkages between Social Security and pensions and will depend on the

responses of employers and workers. For example, individual accounts

could affect private pensions if the employer chooses to change the type of

integration provisions used. To the extent that individual accounts affect

employer costs or workers’ reactions to risk, both employers’ incentives to

provide pension coverage and workers’ incentives to participate in

pensions could be affected.

One expert suggests that integrated pension plans may be affected through

the definition of the Social Security benefit.41 The issue could arise where a

portion of the individual’s total benefit comes from both the individual

account and from Social Security. Plans currently must estimate the

participant’s Social Security benefit to calculate the appropriate offset.

With an individual account, estimating the benefit amount to determine the

appropriate benefit offset could become more complicated and perhaps

costly for the employer. This might compel employers to abandon the

40Social Security Reform: Implications of Private Annuities for Individual Accounts

(GAO/HEHS-99-160, July 30, 1999); 401(k) Pension Plans: Loan Provisions Enhance

Participation But May Affect Income Security for Some (GAO/HEHS-98-5, Oct. 1, 1997).

41Chuck Slusher, “Pension Integration and Social Security Reform,” Social Security Bulletin,

Vol. 61, No. 3, 1998, pp. 20-27.
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offset method in favor of the excess method of integration. For this

method, they need only satisfy the rules regarding permitted disparity and

do not need to calculate the total Social Security benefit accurately.

Depending on their structure, individual accounts could increase employer

costs by increasing contributions and imposing an administrative burden to

maintain the accounts. Employers may respond to the higher costs

associated with contributions to an add-on account in ways similar to those

described for payroll taxes; worker behavior may also be affected. While

large employers appear to be better able to handle the costs and

administrative demands of an individual account system, smaller

employers may face greater difficulties, such as reduced profitability, that

could reduce their willingness to provide pensions.

Worker reactions to the introduction of individual accounts will be shaped

by the way in which they assess risk in relation to their retirement income.

If individual accounts achieve higher rates of returns than beneficiaries

receive under Social Security, and these returns are captured in a way that

improves program financing, the accounts could reduce or mitigate the

benefit cuts and tax increases otherwise needed to pay promised levels of

Social Security benefits.42 Therefore, individual accounts might reduce

workers’ need to adjust to lower anticipated benefit levels or the higher

taxes included in some reform proposals. However, individual accounts

would also likely increase the level of risk or uncertainty associated with

anticipated retirement income.43 Under individual account proposals that

provide for a broad range of investment choices, workers might be able to

choose an appropriate level of risk by adjusting investments within the

account, or they might reallocate their pension-related assets to readjust

the level of risk of their overall portfolios. For example, workers could

offset an increase in risk from the individual account by adjusting the

allocation between fixed income assets and equities in their 401(k)

42Note that depending on the structure of a reform proposal, introducing individual accounts

could increase in the near term the unfunded costs of Social Security (sometimes referred to

as “transition costs”). However, proponents of individual accounts argue that in the long

term, the total costs of meeting existing benefit promises under Social Security will be lower

for individual accounts than for traditional reforms. Martin Feldstein and Andrew Samwick,

“The Transition Path in Privatizing Social Security,” in Privatizing Social Security, Martin

Feldstein, ed. (Chicago: The University of Chicago Press, 1998), pp. 215-64.

43The discussion here focuses on investment risk, but workers can face many other types of

risks regarding retirement income such as longevity risk, inflation risk, and the risks of

death and disability.
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accounts. Workers might also exhibit increased demand for annuity-type

products or perhaps even defined benefit pension arrangements.44 The

ability to adjust to the introduction of individual accounts could be more

problematic for workers who have limited knowledge of investment

principles or who have few or no alternative assetsa sizable portion of

the population. For example, data suggest that about one-quarter of all

families nearing retirement have less than $25,000 in assets such as stocks,

bonds, home equity, and bank accounts.45

Implementing Individual

Accounts Presents

Challenges and

Opportunities

Individual accounts raise a broader set of issues for private pensions

compared with traditional reforms. The design and implementation of

individual accounts will affect not only employer costs but could present

employers and workers with substantial challenges in coordinating existing

defined benefit and defined contribution pension plans with individual

accounts under the current regulatory framework for pensions. At the

same time, an individual account structure could provide an opportunity to

expand access to private retirement income while increasing the choice

and flexibility available to workers.

Employers might seek to offset any higher costs arising from individual

accounts by reducing or restructuring their existing pension plans. If the

accounts achieve investment returns that are below historical trends or the

implicit returns to Social Security, the adjustments that employers and

workers may have to make to maintain expected retirement income could

be exacerbated. For example, if accounts perform below expectations,

workers may desire to delay retirement, which could make it more difficult

for employers who may want to offer early retirement incentives to older

workers. A related issue concerns the degree to which employers would

44Some evidence about change in asset allocation is found in Cori E. Uccello, “401(k)

Investment Decisions and Social Security Reforms,” Working Paper No. 2000-04 (Center for

Retirement Research, Mar. 2000). The author finds that when workers have both a defined

benefit (guaranteed) plan and a supplemental 401(k) plan, there is a tendency to invest more

aggressively in the 401(k) account. This suggests that workers with a guaranteed form of

retirement income such as Social Security will invest more aggressively. Conversely, if the

guaranteed portion is reducedby substituting an individual account, for

exampleworkers might have a tendency to invest less aggressively. Uccello concludes that

the implication for this is that the return to the individual account might be lower. As a

result, the advantages of moving to an individual account system might be overstated.

45Retirement Income: Implications of Demographic Trends for Social Security and Pension

Reform (GAO/HEHS-97-81, July 11, 1997).
B-283947

Page 32 GAO/HEHS-00-187 Social Security Reform

want to, or have to, coordinate their existing pensions with individual

accounts. For example, pensions and individual accounts could have very

different rules for distributing benefits. A 401(k) account currently permits

workers to take lump-sum distributions without penalty at age 591⁄2, while

Social Security individual accounts might restrict distributions until the age

of eligibility for Social Security (62 or later). Existing regulations for

receiving lump sum distributions and the annuity options available to the

worker might also be different for pensions and individual accounts,

complicating administration by the employer. Addressing these challenges

could result in substantial changes in the structure of the pension system,

with possible implications for worker coverage and workers’ overall

retirement income.

At the same time, individual accounts could present an opportunity to

improve the nation’s retirement income system by providing workers with

new opportunities to save for retirement and by expanding workers’

flexibility in managing their retirement assets. One of the most frequently

cited problems with the private pension system is that it does not cover all

workers. A mandatory, universal system of accounts could provide a

defined contribution account to all workers, which would give them access

to private investment returns. While workers may offset their individual

account saving by saving less elsewhere or borrowing more, the ability to

do so may be limited for some and therefore an increase in total saving is

possible.46 It may be argued that individual accounts could increase

workers’ awareness of the need to save for retirement or become more

knowledgeable about investment options. Individual accounts might also

increase employers’ incentive to develop new pension vehicles to

coordinate with individual accounts.

While a voluntary system of individual accounts might draw low

participation, the system could be structured to foster the goal of increased

coverage if it is targeted to those groups with low pension coverage. Such

an account design might also affect the ability and propensity of workers to

save if such a voluntary supplemental saving option were linked with Social

Security. While many employers are concerned about the potential

administrative costs of an individual account system, there may be

46A recent study found evidence that 401(k)s held by low-earning groups are more likely to

represent an addition to net household wealth compared with high-earning groups that hold

401(k)s. Eric M. Engen and William G. Gale, The Effects of 401(k) Plans on Household

Wealth: Differences Across Earnings Groups (Washington, D.C.: The Brookings Institution,

Aug. 2000).
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Page 33 GAO/HEHS-00-187 Social Security Reform

compensating advantages. Some experts have noted that while individual

accounts, either as a supplement to or as a partial substitute for Social

Security, might entail higher administrative costs, these costs might allow

employers to provide workers with greater options and services compared

with Social Security.47 Given a range of investment options, individual

accounts could also provide workers a means of spreading market risk and

perhaps give them more flexibility in terms of retirement choice later in

their careers by allowing them to phase into retirement.

Concluding

Observations

While Social Security and private pensions are linked in many ways, they

remain distinct institutional frameworks for providing retirement income.

Given that little is known about the effects of changes in either of these

systems alone, determining the possible effects and interactions of Social

Security reform across these very different structures is a difficult task.

Furthermore, with the proposed introduction of individual accounts, the

current Social Security debate has introduced the possibility of a major

structural change in the program. Such accounts, often proposed in

combination with other more traditional reforms, raise an even broader set

of possibilities and questions.

Our retirement income institutions operate in a dynamic environment

where workers, employers, and policymakers interact to pursue the goal of

retirement income security. Numerous concurrent influences, such as

changes in tax and regulatory policies, also affect how these institutions

develop and evolve, and the reform debate should explicitly consider these

other issues. The limited knowledge we have of these influences and the

complexity of instituting policy change suggests that any reform should be

taken with caution and careful deliberation. At the same time, establishing

agreement on the fundamental principles underlying the reform should be

emphasized. These principles should include ensuring retirement income

to those who most need it and encouraging the development of new

opportunities to secure and expand the retirement income of future

generations.

47Olivia S. Mitchell, “Administrative Costs in Public and Private Retirement System,” in

Privatizing Social Security, Martin Feldstein, ed.
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Page 34 GAO/HEHS-00-187 Social Security Reform

Agency and Other

Comments

We provided draft copies of this report to the Social Security

Administration, the Department of Labor’s Pension and Welfare Benefits

Administration, and an external reviewer who is a university-based pension

expert. They provided us with technical comments, which we incorporated

where appropriate. In general, they concurred with our treatment of the

issues as appropriate for an overview of the topic and noted that many

issues discussed in the report could benefit from further research.

We are sending copies of this report to the Honorable Charles B. Rangel,

Ranking Minority Member, House Ways and Means Committee; other

interested congressional committees; the Honorable Alexis M. Herman,

Secretary of Labor; the Honorable Lawrence Summers, Secretary of

Treasury; and the Honorable Kenneth S. Apfel, Commissioner of Social

Security. We will also make copies available to others on request. If you

have any questions concerning this report, please contact me at (202) 512-

5491 or Charles Jeszeck at (202) 512-7036. Other major contributors

include Kenneth J. Bombara and Gene Kuehneman.

Sincerely yours,

Barbara D. Bovbjerg

Associate Director

Education, Workforce and

Income Security Issues
Page 35 GAO/HEHS-00-187 Social Security Reform
Page 36 GAO/HEHS-00-187 Social Security Reform

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