United States General Accounting Office

GAO Report to the Chairman and Ranking

Minority Member, Special Committee on

Aging, U.S. Senate

July 1997 RETIREMENT

INCOME

Implications of

Demographic Trends

for Social Security and

Pension Reform

GAO/HEHS-97-81

GAO United States

General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-276326 

July 11, 1997

The Honorable Charles E. Grassley

Chairman

The Honorable John B. Breaux

Ranking Minority Member

Special Committee on Aging

United States Senate

Our nation’s elderly population is growing dramatically. In 1940, when Social Security first paid

benefits, it was 7 percent of the U.S. population; today it is 13 percent. By 2030, the elderly

population will be 20 percent of the population. This demographic trend has profound

implications not just for Social Security but for all sources of retirement income, which also

include pensions, savings, and earnings. While currently most of our nation’s senior citizens

enjoy a reasonable standard of living, this trend raises concerns that our society will continue to

be able to maintain it. This report provides an overview of the trends and key issues relating to

retirement income.

We are sending this report to the Commissioner of Social Security and relevant committees and

subcommittees. The report will be available to others on request.

This report was prepared under my direction. Please contact Francis P. Mulvey, Assistant

Director, at (202) 512-3592 if you have questions.

Jane L. Ross

Director, Income Security Issues
Executive Summary

Purpose The U.S. elderly population has tripled since 1940 and will more than

double by 2050, according to Bureau of the Census projections. The very

old population (aged 85 and over) will increase fivefold. The elderly are

expected to make up 20 percent of the U.S. population as early as 2030

compared with 13 percent today and just 7 percent in 1940. These

dramatic demographic trends pose serious concerns about the future

financing, availability, and protection of retirement income for the nation’s

elderly. Numerous reform proposals under discussion could

fundamentally change the nation’s retirement system.

The Chairman and Ranking Minority Member of the Senate Special

Committee on Aging, concerned about these issues, asked GAO to provide

information on (1) demographic and economic trends affecting retirement

income, (2) the status of Social Security’s long-term financing problems

and proposals to address them, and (3) the extent of pension coverage and

retirement saving and how to ensure that Americans can count on them

throughout their retirement years.

Background The four major sources of retirement income are Social Security, employer

pensions, income from saved assets, and employment earnings. While

Social Security provides income to 90 percent of elderly households, it

provides just 42 percent of their aggregate cash income. Pensions, savings,

and earnings provide income to considerably fewer households but

together provide more than 50 percent of the elderly’s aggregate income.

They largely determine which households have the highest retirement

incomes.

As people live longer and if retirement patterns do not change, Social

Security and employer pensions will cost more or will have to provide

reduced benefits or both. Personal retirement savings will have to last

longer, and workers may find themselves needing to work longer. Federal

policies play a major role in all these sources of retirement income and

will play a significant role in helping adjust to demographic trends.

Title II of the Social Security Act established the Old-Age, Survivors, and

Disability Insurance program, which is generally known as Social Security.

Initially, it provided old-age benefits to nearly all workers in commerce

and industry, or about 60 percent of the workforce. Over the years,

coverage has been expanded to dependents and survivors of insured

workers, disabled workers, and workers in other types of employment.

Page 2 GAO/HEHS-97-81 Retirement Income Issues
Executive Summary

With regard to pensions, the federal government has an interest in

promoting expanded coverage of workers so they can better meet their

retirement income needs. The Employee Retirement Income Security Act

(ERISA) of 1974 focused new attention on making pension promises more

explicit and benefits more secure. In addition to its minimum funding

requirements and other provisions, ERISA established a system of pension

insurance, administered by the Pension Benefit Guaranty Corporation

(PBGC). PBGC assumes liability for certain types of pensions when they are

terminated and pays the pension benefits, subject to certain limits.

Federal tax policy also affects how people save for retirement. Since the

1970s, federal laws have granted favorable tax treatment to individual

retirement accounts (IRA) and the closely related 401(k) pension plans.

Nevertheless, personal saving rates are at a historic low. Finally, federal

policies also affect postretirement earnings. Most notably, provisions in

the Social Security program affect incentives regarding when workers take

benefits and how much beneficiaries choose to earn after retirement.

Results in Brief As the elderly live longer, they will need retirement income over longer

periods. Since fertility rates have been declining, the number of the elderly

will grow as a share of the population. While the income of the elderly has

improved considerably over the past 50 years, demographic trends may

potentially slow or reverse such improvements. Economic growth, if

strong, could ease some of the pressures these trends create. Still, the

nation must confront how the trends will affect the distribution of income

between workers and retirees, between the population’s working and

retirement years, and between high and low earners.

These trends pose long-term financing challenges for both Social Security

and the federal budget. Currently, Social Security revenues exceed

expenditures. The excess revenues are invested by law in federal

government securities and make the total federal deficit lower than it

would be otherwise. However, in just 15 years, expenditures are expected

to exceed cash revenues, according to Social Security Administration (SSA)

projections. At that point, the government’s general fund will have to make

up the difference—in effect, repaying funds owed to Social Security. Such

repayment will present a significant and growing challenge for the overall

federal budget. By 2029, without corrective action, the trust funds will be

depleted, and Social Security’s revenues will fund only 70 to 77 percent of

benefits.

Page 3 GAO/HEHS-97-81 Retirement Income Issues
Executive Summary

To restore Social Security’s long-term financial balance, a number of

reform options are available within the current structure of the program,

such as expanding the number of covered workers or further increasing

the retirement age. However, some proposals go beyond restoring

financial balance and call for fundamentally restructuring the Social

Security system. These proposals attempt to shift more of the

responsibility for retirement income from the federal government to

individuals.

Social Security is meant to provide only a foundation for retirement

income. Pensions, savings, and earnings also represent significant sources

of retirement income and largely determine which households have the

highest retirement incomes. Solutions to Social Security’s problems will

inevitably affect these other sources and could give them an even more

significant role. More workers will eventually receive income from

pensions because of legislative changes regarding vesting and spouse

benefits and also because of women’s increasing labor force participation.

Nevertheless, the proportion of workers covered by pensions at a given

moment has not increased substantially since 1970. In addition, the

national saving rate is at a historic low. Moreover, some trends threaten to

diminish retirement income from pensions and savings. For example,

workers increasingly borrow from their pension savings, cash out their

pensions when they change jobs, or, at retirement, take their pensions as

lump-sum payments rather than a guaranteed life annuity.

Ensuring that Americans have enough retirement income in the

twenty-first century to meet their needs will require that the nation and the

Congress make some difficult choices. Social Security has been an

effective agent for ensuring a reliable source of income in retirement and

greatly reducing poverty among the elderly. The effect of changes to the

system on other retirement income sources and their effects on various

groups within the elderly population should be well understood before

decisions are made. Further, the interplay of budget and savings effects

will have to be carefully considered before any reform proposal is

adopted.

Page 4 GAO/HEHS-97-81 Retirement Income Issues
Executive Summary

Principal Findings

Demographic and

Economic Trends Present

Serious Challenges

Increasing life expectancy and declining birth rates are responsible for the

substantial growth in the number of the elderly as a share of the total

population. The baby-boom generation will simply accelerate this trend.

The elderly will need retirement income over longer periods and will

consume an increasing share of the national output. By 2030, only two

workers are projected to be paying into Social Security for each person

receiving benefits, compared with more than three workers today,

according to SSA actuaries.

Healthy economic growth could ease the pressures of supporting more

retirees with fewer workers. Unfortunately, the rate of national saving and

the growth in real wages and productivity, factors that relate to economic

growth, have slowed notably in the past two decades. Even with strong

economic performance, decisions affecting retirement income policies still

have to be made and will fundamentally influence how the national output

will be divided. They influence how much of total compensation workers

consume now and how much they will consume during retirement. They

also influence how income is redistributed between current workers and

current retirees and between high earners and low earners.

Social Security and pension benefits have helped increase the income of

the elderly over the past 50 years. For example, the share of the elderly

living in poverty has fallen from 35 percent in 1959 to less than 11 percent

today. Still, pockets of poverty remain, especially among those aged 75

and over and among unmarried women.

Addressing Social

Security’s Long-Term

Financing Problem

The growth of the elderly population as a share of the total population

poses serious long-term financing challenges for Social Security. In

January 1997, the Social Security Advisory Council issued its report on the

system’s long-range financial status, but the council members could not

reach agreement on a comprehensive solution. Still, five individual reform

options enjoyed considerable support and, if enacted, would eliminate

about two thirds of the next 75 years’ financing shortfall. These reforms

would modify (1) the retirement age, (2) cost-of-living adjustments (COLA),

(3) the benefit formula, (4) income taxation of benefits, and (5) which

workers are covered under Social Security.

Page 5 GAO/HEHS-97-81 Retirement Income Issues
Executive Summary

While these reform options would work within the current structure of the

program, “privatization” proposals go further and would significantly

restructure Social Security. Such proposals would achieve financial

balance by raising revenues or reducing costs while pursuing other goals,

such as increasing national saving or giving individuals more responsibility

for their retirement income. For example, such proposals would typically

increase the role of individual retirement saving while reducing

government-provided benefits. For many of these privatization proposals,

the transition from the current program to the new system would be quite

expensive. The contributions needed to fund both current and future

liabilities would clearly be higher than those currently collected.

The Social Security Trust

Fund Build-Up and the

Federal Deficit

Solving Social Security’s long-term financing problem would not

necessarily address another significant challenge that the program

presents for the overall federal budget. Currently, Social Security cash

revenues exceed expenditures by roughly $30 billion each year. Under

current law, the Department of the Treasury issues interest-bearing

government securities to the trust funds for these excess revenues. In

effect, Treasury borrows the excess revenues and uses them to help

reduce the amount it must borrow from the public. Moreover, the trust

funds earned $38 billion in interest last year, which Treasury pays by

issuing more securities. If Treasury could not borrow from the trust funds,

it would have to borrow more in the private capital market and pay such

interest in cash.

However, 10 years from now, these excess cash revenues are expected to

start falling, and in just 15 years, Social Security’s expenditures are

expected to exceed its cash revenues. The government’s general fund will

have to make up the difference, in effect repaying Social Security. As a

result, the federal deficit will increase, unless offset by spending

reductions or revenue increases. In 2028, repayments from the general

fund to Social Security are expected to reach about $183 billion in 1997

dollars. In that year, this amount would equal 1.4 percent of gross

domestic product (GDP), which is the same share of GDP as last year’s

deficit for the entire federal government.

Strengthening Employer

Pensions and Personal

Retirement Savings

Employer pensions and personal retirement savings are also significant

sources of retirement income. About 47 percent of workers had private

pension coverage in 1993. Although this coverage rate has changed little

since the 1970s, more workers will eventually receive income from

Page 6 GAO/HEHS-97-81 Retirement Income Issues
Executive Summary

pensions because of legislative changes in the 1980s regarding vesting and

spouse benefits and also because of women’s increasing labor force

participation. Still, these changes also imply smaller average pension

benefits because they will reflect the shorter job tenures of these workers

who would not have received pensions previously. Also, joint-and-survivor

annuities yield smaller monthly benefits than worker-only annuities. In

addition, complex pension regulations may deter employers from

sponsoring pensions. Current proposals to expand pension coverage focus

on simplifying some of the regulations.

Efforts to increase personal savings outside pension arrangements seem to

have had only marginal success. Many households do not save in any

systematic way, and personal saving rates have declined by nearly half

since 1970. Preferential tax treatment for 401(k) and individual retirement

accounts seems to encourage saving, but such saving may substitute, at

least partly, for other types of saving.

To help meet the nation’s retirement income challenges, pensions and

savings must be secure and wisely managed. While tax laws discourage

using pension assets for nonretirement purposes, the laws do not strictly

prohibit such use. Some workers cash out their pension accounts when

they change jobs, despite penalties and tax liabilities. At retirement, most

take their pensions as a lump sum, which they must carefully manage to

provide income for the rest of their lives. In addition, most plans allow

workers to borrow from their accounts for specified purposes. The loan

option may encourage workers to contribute more to these accounts and,

in some cases, such as borrowing for educational expenses, could result in

greater retirement income security. However, if they do borrow, they may

reduce the savings available for retirement.

In the case of retirement savings and some pension plans, workers control

how their savings are invested. However, many workers may lack the

information necessary to get higher investment earnings. Research shows

that educating employees in how to manage their funds can increase both

their retirement contributions and investment returns.

Recommendations GAO is not making recommendations in this report.

Agency Comments GAO obtained comments on this report from SSA and from subject matter

experts. They did not express any disagreement with the overall message

Page 7 GAO/HEHS-97-81 Retirement Income Issues
Executive Summary

of the report. They did suggest some technical corrections, which have

been incorporated as appropriate.

Page 8 GAO/HEHS-97-81 Retirement Income Issues
Page 9 GAO/HEHS-97-81 Retirement Income Issues
Contents

Executive Summary 2

Chapter 1 

Introduction

12

The Sources of Retirement Income 12

Objectives, Scope, and Methodology 14

Chapter 2 

Demographic and

Economic Factors

Affect Retirement

Income

15

The Elderly Population Is Growing in Number and Proportion 15

Economic Trends Affect Earnings and Future Retirement Income 20

The Income of the Elderly Has Improved 21

Chapter 3 

Social Security’s

Financing Challenges

29

Addressing Social Security’s Long-Term Financing Problems 29

Social Security Trust Funds and the Federal Deficit 40

Chapter 4 

Private Pensions and

Retirement Saving

Can Help With

Retirement Income

Challenges

42

Federal Policies Promote Pension Coverage and Benefit Security 42

More Will Receive Pensions Although Coverage Has Not Grown

Recently

43

Efforts to Increase Personal Retirement Saving Have Not Been

Successful

46

Will Pensions and Savings Be There for Retirement? 47

Chapter 5 

Concluding

Observations

50

Appendix Appendix I: Major Contributors to This Report 52

Related GAO Products 56

Table Table 2.1: Elderly Households’ Median Income by Types of

Income and by Income Distribution, 1994

26

Page 10 GAO/HEHS-97-81 Retirement Income Issues
Contents

Figures Figure 2.1: Population Aged 65 and Over, by Age Group,

1940-2050

16

Figure 2.2: Trends and Projections of Life Expectancy at Age 65,

1940-2060

17

Figure 2.3: Historical and Projected Dependency Ratios,

1960-2040

19

Figure 2.4: Median Income Levels and the Poverty Threshold,

Unmarried Persons Aged 65 and Over, 1978-94

22

Figure 2.5: Share of Elderly Households Receiving Various Types

of Income, 1994

23

Figure 2.6: Share of Elderly Households’ Income by Types of

Income, 1994

24

Figure 2.7: Pensions, Savings, and Earnings Determine Who Will

Have Highest Retirement Incomes, 1994

25

Figure 2.8: Poverty Rates by Age Group, 1959-94 27

Figure 3.1: Social Security’s Revenues Exceed Expenditures Now

but Fall Short Later

41

Abbreviations

AIME average indexed monthly earnings

COLA cost-of-living adjustment

CPI Consumer Price Index

DB defined benefit

DC defined contribution

DOL Department of Labor

ERA early retirement age

ERISA Employee Retirement Income Security Act

GDP gross domestic product

IRA individual retirement account

IRS Internal Revenue Service

NRA normal retirement age

PBGC Pension Benefit Guaranty Corporation

PIA primary insurance amount

SEP simplified employee pension

SIMPLE savings incentive match plan for employees

SSA Social Security Administration

TSP Thrift Savings Plan

Page 11 GAO/HEHS-97-81 Retirement Income Issues
Chapter 1 

Introduction

As the U.S. population ages, there will be growing pressures on Social

Security and pension programs to provide retirees with the retirement

income they need. For more than 60 years, the Social Security program

has helped protect America’s elderly from living in poverty, but it now

faces a long-term financing problem. Proposals to address the problem are

wide-ranging, and many, if adopted, could fundamentally change the

nation’s retirement system.

The Sources of

Retirement Income

When individuals retire from their principal employment, they may receive

income from one or more of several sources, primarily Social Security,

pensions, personal savings, and earnings from subsequent work. Federal

policies play a major role in all these sources of retirement income.

Moreover, they affect how income is distributed between workers and

retirees, between high and low earners, and between individuals’ working

and retirement years.

The Social Security Act was signed into law by President Franklin D.

Roosevelt in August 1935 in response to the crisis Americans faced during

the Great Depression. The retirement component of the act initially

provided benefits upon retirement to workers in commerce and industry

who had contributed to the program over a portion of their working lives.

Social Security was meant to provide a retirement income foundation

upon which individuals could build for their retirement years. It was a

social insurance program. Over the years, the size and scope of the

program has changed. In 1939, coverage was extended to provide benefits

for some family members and survivors. In the 1950s, state and local

governments were given the option of covering their employees. The

Disability Insurance program was added in 1956, providing income for

disabled workers. The Medicare program was added in 1965. Beginning in

1975, benefits were automatically tied to the Consumer Price Index (CPI) to

ensure that the purchasing power of recipients’ income was not eroded by

inflation.

Because the Social Security program was designed as a pay-as-you-go

system with current benefits paid out of current income (primarily from

payroll taxes), it experienced periodic financing difficulties as coverage

and benefits increased and as the number of retirees increased relative to

the number of contributors. Payroll taxes increased from an initial

2 percent on the first $3,000 of earnings (1 percent each from employers

Page 12 GAO/HEHS-97-81 Retirement Income Issues
Chapter 1 

Introduction

and employees) to 12.4 percent on the first $65,400 of earnings today. For

many Americans, the payroll tax is now the largest tax they pay.

Some of the increases in payroll taxes were always anticipated as a natural

result of the maturing of the Social Security system and its pay-as-you-go

financing. The first benefits were paid only to individuals who had already

made some contributions to the system. In the early years, a very small

share of the elderly qualified for benefits, and larger payroll taxes were not

required. As more and more of the elderly received benefits, higher payroll

taxes were required. While such increases had always been anticipated,

some of the payroll tax increases resulted from benefit increases,

especially cost-of-living adjustments, and eligibility expansion such as

survivor and disability benefits.

Pensions are the second major source of retirement income. Private

pensions grew rapidly in popularity between 1900 and 1920 until about one

worker in six was covered—typically those working in the transportation,

banking, mining, utility, and manufacturing industries. Pension coverage

basically held its own during the Great Depression and again grew rapidly

between 1940 and 1960 and continued to increase into the 1970s when

coverage leveled off at just under half the workforce. Workers nearing

retirement are the most likely to have pension coverage.

The federal government has an interest in promoting expanded pension

coverage of workers so they can better meet their retirement income

needs and because expanded coverage increases national saving. In

addition, the Employee Retirement Income Security Act of 1974 (ERISA)

focused new attention on making pension promises more explicit and

benefits more secure. This act established guidelines for operating pension

funds and set specific requirements for various pension plan provisions.

These new rules and subsequent regulations have raised the costs of

employer-provided defined benefit plans and have affected the growth of

defined contribution plans, including 401(k) plans. Under defined

contribution plans, the benefits are not certain, as they are under defined

benefit plans; they vary depending on the level of contributions made to

the pension and the performance of the investment portfolio.

The rate of personal saving, the third source of retirement income, is at a

historic low. Moreover, the very low rate of national saving has raised

concern among many economists about the long-term effects on national

economic growth because saving helps spur investment, which in turn

contributes to economic growth.

Page 13 GAO/HEHS-97-81 Retirement Income Issues
Chapter 1 

Introduction

Finally, the last source of retirement income, employment earnings, may

become increasingly important if the other sources fail to provide

sufficient income to meet the needs of future retirees. Federal policies

affect such earnings in that Social Security provisions affect when workers

retire and how much they choose to earn after retirement. Also, federal

policies regarding health insurance, whether concerning Medicare,

Medicaid, or employer-provided retiree health insurance, influence when

workers retire.

Objectives, Scope,

and Methodology

The Chairman and Ranking Minority Member of the Senate Special

Committee on Aging asked us to review current and emerging issues

relating to retirement income. First, we identified the economic and

demographic trends affecting retirement income. Second, we examined

the status of Social Security’s long-term financing problems and proposals

to address it. Third, we examined the extent of pension coverage and

retirement saving and how to ensure that retirees can count on them

throughout retirement.

In conducting this study, we reviewed the literature and public record

relating to retirement income policy. We also examined data on retirement

income sources and the demographics of the elderly population. Our data

sources included official Social Security data, especially from the 1996

Trustees’ Report, Census data, and data from the Health and Retirement

Survey, prepared by the University of Michigan Survey Research Center.

We looked at relevant legislation and proposals affecting retirement

income. We discussed retirement income issues with several experts from

government, research institutes, and benefit consulting firms. We

conducted our work between March 1996 and May 1997, using generally

accepted government auditing standards.

Page 14 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2 

Demographic and Economic Factors Affect

Retirement Income

The U.S. elderly population has tripled since 1940 and will more than

double again by 2050, according to Census projections, and is accounting

for a growing share of the total population.1

 As people live longer and have

fewer children, the number of workers per retiree is declining. Moreover,

the elderly will consume an increasing share of the national output. A

healthy rate of real economic growth could help ease the pressures

created by these challenges, but the prospects for such growth are

unclear. Whatever the outcome, federal retirement policies will help

determine how national income will be distributed. In fact, the growth in

Social Security and private employer pensions since 1940 has contributed

substantially to increasing income and reducing poverty among the

elderly.

The Elderly

Population Is Growing

in Number and

Proportion

In the United States, the elderly population grew from about 9 million in

1940 to about 34 million in 1995, and it is expected to reach 80 million by

2050, according to Census projections.2

 Moreover, the very old population

(those aged 85 and over) is expected to increase fivefold, from about

4 million in 1995 to nearly 19 million in 2050. (See fig. 2.1.) As a share of

the total U.S. population, the elderly population grew from 7 percent in

1940 to 12 percent in 1990; this share is expected to increase to 20 percent

by 2050. Other nations, both developed and developing, are experiencing

similar and often more pronounced trends.

1

In this report, we use “elderly” to refer to people aged 65 and over. However, the “retired” population

is not so clearly defined; many retire before reaching age 65 and some continue working afterward. We

use age 65 primarily because age group data often use age 65 as a break point.

2

In its population projections, Census uses alternative assumptions of high, middle, and low rates of

fertility, mortality, and immigration. These projections reflect the middle assumptions set. Some

demographers project even more dramatic growth in the elderly population than Census or Social

Security actuaries do. In particular, the 1994-96 Social Security Advisory Council’s Technical Panel on

Assumptions and Methods noted that Social Security’s mortality assumptions reflect a lower rate of

mortality improvements than may be warranted.

Page 15 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2 

Demographic and Economic Factors Affect

Retirement Income

Figure 2.1: Population Aged 65 and Over, by Age Group, 1940-2050

1940 1960 1980 2000 2020 2040

0

20

40

60

80

Population (Millions)

65-74

75-84

85+

Note: Data for 2000-2050 are midrange Census projections.

Source: U.S. Bureau of the Census, 65+ in the United States (Washington, D.C.: 1996).

Although the baby-boom generation will contribute heavily to the growth

of the elderly population, other demographic trends are also important.

Increasing life expectancy, for example, is another major factor. Figure 2.2

shows that life expectancy has increased continually since the 1930s and

that further improvements are expected. In 1940, the life expectancy of

persons at age 65 was 12 years for men and 13 years for women. By 1995,

life expectancy at aged 65 improved to 15 years for men and 19 for women

Page 16 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2 

Demographic and Economic Factors Affect

Retirement Income

and, by 2040, it is projected to be 17 years and 21 years, respectively,

according to SSA’s intermediate actuarial assumptions.3

Figure 2.2: Trends and Projections of Life Expectancy at Age 65, 1940-2060

1940 1960 1980 2000 2020 2040 2060

0

5

10

15

20

25

11.9

12.9

14

15.6

16.5

17.3

18

13.4

15.9

18.4

19.4

20.1

21

21.8

Years

Men

Women

Note: Projections for 2000-2060 are based on the trustees’ intermediate actuarial assumptions.

Source: 1996 Annual Report of the Board of Trustees of the Federal Old Age and Survivors

Insurance and Disability Insurance Trust Funds.

A falling fertility rate is the other principal factor underlying the growth in

the elderly’s share of the population. Fertility rates rose from about 2.2

children per woman in 1940 to a peak of about 3.6 children per woman

3

For the annual report of the Board of Trustees for the Social Security Trust Funds, SSA actuaries

project future revenues and benefits. For these projections, they use alternative assumptions regarding

economic and demographic trends, including average earnings, mortality, fertility, and immigration.

The intermediate assumptions represent the board’s best estimate of future trends.

Page 17 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2 

Demographic and Economic Factors Affect

Retirement Income

around 1960. Since then, the rate has declined to around 2.0 children per

woman today and is expected to level off at about 1.9 by 2020, according

to SSA’s intermediate assumptions.

The dependency ratio, the number of working-age adults (aged 20 to

64) divided by the number of elderly adults, illustrates the society’s

increasing burden of supporting the elderly. The dependency ratio

declined from 5.8 in 1960 to 4.7 in 1995 and is expected to decline further

to 2.7 in 2040. Looking just at Social Security, there were 3.3 workers for

each aged or disabled beneficiary in 1995, but by 2030, there are expected

to be only 2.0 workers for each beneficiary. (See fig. 2.3.)

Page 18 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2 

Demographic and Economic Factors Affect

Retirement Income

Figure 2.3: Historical and Projected Dependency Ratios, 1960-2040

1960 1970 1980 1990 2000 2010 2020 2030 2040

1

2

3

4

5

6

Dependency Ratio

Aged

Social Security

Note: Here, the “aged” dependency ratio is the number of people aged 20-64 per aged person

(aged 65 and over). The Social Security dependency ratio is the number of workers paying Social

Security taxes per aged or disabled beneficiary. Projections use SSA’s intermediate actuarial

assumptions.

Source: 1996 Annual Report of the Board of Trustees of the Federal Old Age and Survivors

Insurance and Disability Insurance Trust Funds.

In the future, there will be relatively fewer younger persons to work and

support a growing number of aged retirees unless retirement patterns

change. In particular, there will be relatively fewer workers to pay the

Social Security taxes needed to fund benefits.4

 At the same time, Social

Security, pensions, and other retirement income will have to provide

income over longer periods as life expectancies rise. As a result,

4

Social Security benefits are expected to increase from 4.7 percent of gross domestic product today to

6.4 percent in 2030, according to SSA’s intermediate projections.

Page 19 GAO/HEHS-97-81 Retirement Income Issues
Chapter 2 

Demographic and Economic Factors Affect

Retirement Income

contributions to Social Security and to pension plans must increase or

benefits must be reduced or both. Yet increasing payroll taxes or

constraining wage growth could make it harder for workers to save for

their own future, while cutting benefits will increase their need to save.

Economic Trends

Affect Earnings and

Future Retirement

Income

Our nation’s ability to meet its retirement income challenges depends

substantially on how well the economy performs. Retirement contribution

rates and benefit levels mostly affect how the nation’s output—its

economic pie—will be divided. High rates of economic growth would

increase the size of the pie. In particular, growth in inflation-adjusted

wages (real wages) affects all types of retirement income. Earnings largely

determine Social Security and pension benefit amounts and affect how

much workers can or want to save. In addition, real wage growth

increases the ability and possibly the willingness of workers to absorb any

tax increases or benefit cuts that might be necessary for Social Security’s

long-term financial balance.

Unfortunately, real wage growth has slowed over the last two decades,

largely reflecting slowing productivity growth. This contrasts with the 25

years after World War II when the standard of living doubled, helping

improve the economic status of today’s elderly relative to that of previous

generations. However, various measures of real wage growth exist.

Measures that incorporate fringe benefits, such as pensions, and that use

different inflation estimates suggest that real compensation has slowed

but not necessarily stagnated.5

As long as real wage growth is positive, living standards do improve. In

fact, a Congressional Budget Office study reports that both the real

incomes and wealth of the baby-boom generation are notably better than

those of their parents at a similar age.6

 Positive real wage growth,

increasing labor force participation by women, and changes in ERISA rules

in 1986 that increased the number of workers who will ultimately receive a

pension all contribute to the prospect of higher inflation-adjusted

retirement incomes for the baby-boom generation.

Income inequality, which has implications for the distribution of

retirement income, has widened in recent years. For example, in 1979, of

male workers 25 years old and older, the top tenth earned 3.2 times more

5

Daniel Sullivan, “Trends in Real Wage Growth,” Chicago Fed Letter, No. 115 (Mar. 1997).

6

Congressional Budget Office, Baby Boomers in Retirement: An Early Perspective, (Washington, D.C.:

Sept. 1993).

Page 20 GAO/HEHS-97-81 Retirement Income Issues
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Demographic and Economic Factors Affect

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than the bottom tenth, but by 1993, the top tenth was earning 4.1 times as

much as the bottom tenth. Explanations for this include, among others, an

increased demand for a relatively small number of highly skilled workers

as a result of technological change. At the same time, the part of the

service sector that employs relatively low-skilled workers has also grown.

For persons at the low end of the income distribution, their retirement

incomes will be lower, and more of them might qualify for means-tested

income support and other programs available to the elderly poor.

The Income of the

Elderly Has Improved

Since 1940, Social Security, pensions, and savings have dramatically

improved the income of the elderly. Accordingly, poverty rates for the

elderly have declined substantially, but pockets of poverty remain. Social

Security provides a strong foundation of retirement income, but pensions,

savings, and earnings determine which households will be relatively better

off in their retirement years. Figure 2.4 shows the increase in total income

and Social Security benefits for the elderly relative to the poverty

threshold. Because the threshold varies by household composition, this

figure uses unmarried persons aged 65 and over only as an example.7

7

About 60 percent of elderly households were nonmarried persons. Of these, 77 percent were

nonmarried women. In contrast to nonmarried persons, married couples received median Social

Security benefits that exceeded the poverty line in each year and by an increasing amount. This

reflects the lower poverty rates of married couples.

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Figure 2.4: Median Income Levels and the Poverty Threshold, Unmarried Persons Aged 65 and Over, 1978-94

1978 1980 1982 1984 1986 1988 1990 1992 1994

2,000

4,000

6,000

8,000

10,000

12,000

Income (Dollars)

Total Retirement Income

Social Security

Poverty Line

Source: Susan Grad, Income of the Population 55 and Over (Washington, D.C.: SSA, Office of

Research and Statistics, 1981-96).

Sources of Retirement

Income

In 1994, about 91 percent of all elderly households received Social Security

benefits, 67 percent received some income from saved assets, just over

40 percent received pensions, and 21 percent received earned income.

(See fig. 2.5.) The percentage of elderly persons receiving Social Security

benefits has remained stable over the past 20 years while the share

receiving income from assets and pensions has increased by about

10 percentage points each. The percentage receiving income from earnings

has fallen slightly, reflecting the reduced labor force participation of

elderly men.

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Figure 2.5: Share of Elderly Households Receiving Various Types of Income, 1994

Social Security Savings Pensions Earnings

0

20

40

60

80

100

91

67

42

21

Percentage of Elderly Households

Source: Susan Grad, Income of the Population 55 or Older, 1994 (Washington, D.C.: SSA, Office

of Research and Statistics, 1996).

Social Security benefits contribute the most to the elderly’s aggregate cash

income, accounting for 42 percent. (See fig. 2.6.) The three other sources

contribute about 18 percent each to aggregate elderly income, even though

the share of elderly households receiving each type of income varies

considerably. Their contributions to aggregate income have fluctuated.

For example, savings have ranged between 18 and 28 percent of total

elderly income since 1978.

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Demographic and Economic Factors Affect

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Figure 2.6: Share of Elderly

Households’ Income by Types of

Income, 1994 Social Security

Savings

Pensions

Earnings

Other

42%

18%

19%

18%

4%

Source: Susan Grad, Income of the Population 55 or Older, 1994 (Washington, D.C.: SSA, Office

of Research and Statistics, 1996).

While Social Security provides a strong foundation for retirement income,

it is only a foundation. In 1994, Social Security provided an average of

roughly $9,200 to all elderly households. Figure 2.7 and table 2.1 show the

dollar contributions from each source of elderly income by income level

for 1994. Social Security’s contribution plateaued at roughly $10,000 in the

highest three quintiles. Social Security provided 81 percent of the

aggregate income for each of the bottom two fifths of the income

distribution but just 23 percent for the top fifth. The second largest source

of income for those in the bottom fifth was public assistance, which

provided about 11 percent of their total income. Pensions, savings, and

earnings determine which households have the highest retirement

incomes. They each contributed an average of more than 20 percent of

income to the top fifth of the income distribution but less than 4 percent to

the lowest fifth. Saved assets, for example, provided income to more than

90 percent of elderly households in the top fifth but to only 30 percent in

the lowest fifth.

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Figure 2.7: Pensions, Savings, and Earnings Determine Who Will Have Highest Retirement Incomes, 1994

First Second Third Fourth Fifth

0

10,000

20,000

30,000

40,000

50,000

5,665

9,785

15,075

23,605

45,000

Income Level (Quintile)

Elderly Household Income (Dollars)

Social Security

Savings

Pensions

Earnings

Other

Note: Median incomes for each quintile are GAO estimates. Social Security income for the highest

fifth may be lower than for the previous fifth because, among other possible reasons, some

elderly workers or their spouses may not yet be collecting benefits.

Source: GAO analysis of data from Susan Grad, Income of the Population 55 and Older, 1994

(Washington, D.C.: SSA, Office of Research and Statistics, 1996).

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Table 2.1: Elderly Households’ Median

Income by Types of Income and by

Income Distribution, 1994

Income level (quintile)

First Second Third Fourth Fifth

Social Security $4,600 $7,936 $9,934 $11,401 $10,215

Savings 153 528 1,553 3,399 10,980

Pensions 181 724 2,126 5,642 9,495

Earnings 11 215 935 2,573 12,825

Other 720 382 528 590 1,485

Total $5,665 $9,785 $15,075 $23,605 $45,000

Note: Median incomes for each quintile are estimates. Social Security income for the highest fifth

may be lower than for the previous fifth because, among other possible reasons, some elderly

workers or their spouses may not yet be collecting benefits. Totals may not add because of

rounding.

Source: GAO analysis of data from Susan Grad, Income of the Population 55 and Older, 1994

(Washington, D.C.: SSA, Office of Research and Statistics, 1996).

The Poverty of the Elderly

Has Declined, but Pockets

Remain

Poverty rates for the elderly declined dramatically from 35 percent in 1959

to under 11 percent in 1995. (See fig. 2.8) In 1994, 11.7 percent of persons

aged 65 and over were poor compared with 11.9 percent of adults aged

18-64 and 21.2 percent of children under 18.8

8

The poverty threshold in 1994 was $8,967 for a two-person elderly household with no related children.

The poverty index is based solely on money income and does not reflect noncash benefits such as food

stamps, Medicaid, and public housing.

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Figure 2.8: Poverty Rates by Age Group, 1959-94

1959 1964 1969 1974 1979 1984 1989 1994

0

10

20

30

40

Percentage of Population

Adults 65+

Children <18

Adults 18-64

Data Not Available

1959 Data

Note: Estimates for adults 65+ and adults 18-64 are not available for 1960-65.

Source: U.S. Bureau of the Census.

Social Security has contributed substantially to reducing poverty among

the elderly.9

 Excluding Social Security benefits, the incomes of about

54 percent of persons aged 65 or older would have been below the poverty

threshold in 1994.10 Still, even with various government benefits, almost

9

Means-tested public assistance programs such as Supplemental Security Income, Food Stamps,

Medicaid, and housing programs also attempt to alleviate poverty for the elderly and others. While

these programs are beyond the scope of this report, they are an integral part of income support

policies for the poor, including the elderly. Changes in retirement income policy implicitly affect these

programs as well as the poverty of the elderly.

10However, without Social Security, people might save more or continue working.

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30 percent of elderly households are poor or near-poor; here, the

“near-poor” are persons with incomes between 100 and 150 percent of the

poverty threshold.

Poverty tends to affect particular subgroups of the elderly population

disproportionately. For persons 75 and older in 1992, 35 percent were poor

or near-poor, roughly the same percentage as for children. Poverty status

also varies significantly by gender and marital status. Single, widowed, or

divorced women are much more likely to live in poverty than couples or

unmarried men. About 22 percent of unmarried women aged 65 or older

are poor, compared with 15 percent of unmarried men and 5 percent of

married couples. Unmarried women make up over 70 percent of poor

elderly households.

Health Costs Demand a

Growing Share of

Retirement Income

Health care costs are substantially greater for the elderly than for others

and place growing demands on their incomes, even with public and private

health care insurance. Out-of-pocket health costs consumed 21 percent of

elderly household income in 1994, according to an analysis of the 1987

National Medical Expenditure Survey and data from other government and

insurance industry sources.11 The 1994 values were projected from the

1987 survey data, using trend data from other sources. The elderly pay

42 percent of their noninstitutional health costs, not including premiums.12

Including premiums, the elderly’s out-of-pocket health costs in 1994 were

projected to average $2,519 per person, which is nearly four times greater

than for the nonelderly. After adjusting for inflation, the elderly spent

more than twice as much in 1991 on out-of-pocket costs as they did before

Medicare was enacted in 1965.

11Out-of-pocket expenses include premiums, deductibles, and copayments as well as costs not covered

by insurance at all. However, the data presented here do not include Medicare Part A insurance

premium contributions. AARP Public Policy Institute and the Urban Institute, Coming Up Short:

Increasing Out-of-Pocket Health Spending by Older Americans, No. 9507 (Washington, D.C.:

Apr. 1995).

12In the case of long-term care, consumers paid 33 percent of the costs out-of-pocket in 1993.

Page 28 GAO/HEHS-97-81 Retirement Income Issues
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Social Security’s Financing Challenges

Social Security plays a major role in providing retirement income. It pays

benefits to more than 90 percent of elderly households and provides more

than 40 percent of total elderly income. However, the elderly population is

growing in both number and proportion, and as a result, the program faces

serious long-term financing problems. Because of previous efforts to

address long-term financing issues, the Social Security trust funds are

building up substantial reserves to help pay future benefits. These reserves

are invested in government securities. However, drawing down the trust

funds will have significant implications for the federal budget when the

time comes to do so.

Addressing Social

Security’s Long-Term

Financing Problems

Although Social Security’s revenues currently exceed its expenditures,

revenues are expected to be about 14 percent less than total projected

expenditures over the next 75 years. In 2031, the last members of the

baby-boom generation will reach age 67, when they can receive full

retirement benefits under current law. In 2029, the Social Security trust

funds are projected to be depleted. In 2030 and each year thereafter, Social

Security revenues are expected to be sufficient to pay only 70 to

77 percent of benefits, given current law and SSA’s intermediate

assumptions about demographic and economic trends.

Restoring Social Security’s long-term financial balance will require some

combination of increased revenues and reduced expenditures.13 A variety

of options is available within the current structure of the program.

However, some proposals would fundamentally alter the structure of the

Social Security program. These more dramatic changes go beyond

restoring financial balance and attempt to achieve other policy objectives

as well.

In addition to ensuring program solvency, a variety of policy objectives

underlie Social Security’s program structure or proposals to reform it,

such as

• helping ensure that the elderly do not live in poverty;

• promoting benefit “equity”—that is, reducing the variation in the implicit

rates of return that participants receive on their contributions;

• giving individuals greater control and responsibility for their retirement

income;

• increasing personal and national saving; and

13Decreasing the administrative costs of the program will not save much money. Current

administrative expenditures are less than 1 percent of program expenditures for Old Age and Survivors

Insurance.

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Social Security’s Financing Challenges

• reducing future federal budget deficits.

In addition, financing reforms could affect the nation’s economy in various

ways. For example, increasing national saving or reducing tax burdens

could promote economic growth. Reforms that would invest Social

Security revenues in the stock market or require increased federal

borrowing could affect stock prices and bond interest rates. Raising the

retirement age could affect the labor market for elderly workers.

Reforms would have effects on other sources of retirement income and

related public policies as well. For example, increasing payroll taxes could

affect the ability of workers to save for retirement. Raising Social

Security’s retirement age or cutting its benefit amounts could increase

costs for private pensions that adjust benefits in relation to Social Security

benefits. They would also interact with other income support programs

such as Social Security’s disability insurance or the Supplemental Security

Income public assistance program.

Reforms could have both immediate effects and effects far into the future.

For example, bringing newly hired state and local government workers

into the Social Security system would immediately increase revenues but

would increase benefit payments only when the newly covered workers

retire. However, even changes that take effect years from now can affect

how workers plan for their retirement now, especially how much they

choose to save. Therefore, the sooner solutions are enacted, the more time

workers will have to adjust their retirement planning. Acting sooner rather

than later also means that the funding shortfall can be addressed over a

longer period at a lower annual cost.

Finally, any financing reforms would implicitly have distributional effects.

For example, increasing Social Security taxes would reduce the disposable

income of current workers but would help sustain retirement benefits for

current retirees and possibly for themselves when they retire. Cutting

benefits instead of increasing payroll taxes would have the opposite

distributional effect. Also, Social Security redistributes income from high

to low earners to some degree; some reforms would change this

redistribution.

Options Within Social

Security’s Current

Structure

A wide range of options is available for reducing costs or increasing

revenues within the current structure of the Social Security program.

Previously enacted reforms have used many of these in some form.

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Social Security’s Financing Challenges

Current reform proposals also rely, at least in part, on many of these more

traditional measures, regardless of whether the proposals largely preserve

the current program structure or alter it significantly.

Examples of reducing program expenditures include

• reducing initial benefits by changing the benefit formula for all or some

beneficiaries;

• raising the retirement age, which implicitly reduces initial benefits;

• lowering or eliminating the annual COLAs; and

• means-testing benefits.

Examples of increasing revenues include

• increasing income taxes on Social Security benefits,

• increasing Social Security payroll taxes, and

• investing trust funds in the stock market.

Reducing Initial Benefits

Through the Benefit Formula

One way to reduce benefits would be to modify the formula used to

determine benefit amounts for each retired or disabled recipient.

Determining benefit amounts starts by computing a measure of average

lifetime earnings. For each year, the worker’s covered earnings are

updated, or indexed, to reflect the change in average earnings for the

national economy.14 For retired worker benefits, the average is computed

using the highest 35 years of indexed earnings. Some propose increasing

the computation period to 38 years.15 Because the current formula uses the

years with the highest earnings, additional years would be those with

lower earnings and would thereby lower the average. This change would

likely decrease benefits more for women than for men, because women

usually have more years with zero earnings.

14Noncovered earnings include any over the maximum taxable earnings ($65,400 per year for 1997) and

any earnings in noncovered employment. Changes in average earnings reflect changes in real wages as

well as wage inflation. Therefore, this indexing captures some of the improvement in the standard of

living.

15For example, the Ball proposal included in the recent Social Security Advisory Council Report. (See

“Current Proposals Mix Several Elements.)

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Social Security’s Financing Challenges

In addition, the benefit formula provides that benefits are higher for

workers with higher lifetime earnings but less than proportionately so.16

This “progressive” formula redistributes income from high earners to low

earners to help keep low earners out of poverty. At the same time, the

formula attempts to maintain some degree of equity for higher earners by

providing that benefits increase somewhat with earnings. The specific

parameters of the formula implicitly reflect a particular balance between

these adequacy and equity concerns.

Modifying the formula could include changing the parameters that

determine the progressivity of the formula. Such changes could reduce

benefits for high earners but leave low earners’ benefits unchanged.

However, this could raise equity concerns because high earners would get

lower benefits relative to their earnings than they do now. Alternatively,

parameter changes could reduce benefits across the board, which could

raise concerns that persons with the lowest benefits might not get the

retirement income they need.

In addition, initial benefits could be reduced by changing the adjustments

for early or delayed retirement. Such changes should increase the

incentive to postpone retirement and continue working.

Raising the Retirement Age Raising the retirement age would reduce benefit costs and could involve

increasing the normal retirement age (NRA), the early retirement age (ERA),

or both. The appropriate age for retirement has arguably changed because

life expectancy has increased and the health of the elderly has improved.

However, these improvements have been enjoyed primarily by those with

higher education and socioeconomic status.

Under current law, persons who retire before the NRA receive reduced

benefits; those who retire after the NRA receive increased benefits.

Therefore, raising the retirement age implicitly has the effect of reducing

initial benefits for all retirees. For example, under current law, persons

who retire at today’s NRA of 65 would get the basic benefit amount, without

adjustments for either early or delayed retirement. As the NRA increases to

age 67, persons who still retire at age 65 will have their basic benefits

reduced for early retirement. Those in the same age group who retire at

16Specifically, the “primary insurance amount” (PIA) is the full monthly benefit payable to retired

workers at age 65 or to disabled workers when first entitled. For those entitled to benefits in 1997, the

PIA equals (1) 90 percent of the first $455 of average indexed monthly earnings (AIME), plus

(2) 32 percent of the next $2,286 of AIME, plus (3) 15 percent of AIME over $2,741. The bend points in

this formula (dollar amounts of AIME defining each bracket) are indexed to increases in average

national earnings.

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other ages would see larger reductions for early retirement or smaller

increases for delayed retirement than they would under current law.

Raising the ERA as well as the NRA would eliminate retired worker benefits

entirely until workers reach the new ERA. More than 50 percent of newly

retired workers currently receive benefits at age 62, and more than two

thirds retire before age 65. Therefore, the cost savings from increasing the

ERA would be substantial. However, some workers who would have retired

before age 65 would still qualify for Social Security under the Disability

Insurance program.

Reforms relating to the retirement age could provide incentives to work

longer, but their effects also depend to some degree on the labor market’s

response. Having people work longer would help with the demographic

problem of the declining ratio of workers to retirees. Working longer could

increase workers’ Social Security and pension benefits and allow them to

increase their savings rather than spend them. Still, it remains unclear

whether workers will want to work longer, whether they will need to

because of benefit reductions, and whether employers will provide

attractive opportunities to continue working rather than incentives to

retire early. In recent years, workers have been retiring earlier, not later,

and not always by choice. Less than one sixth of men aged 65 and over are

in the labor force today, compared with nearly half in 1950.

Reducing COLAs Since 1975, Social Security benefits have been automatically increased to

keep pace with inflation and maintain their purchasing power. However,

some believe that the CPI, which is used to determine COLAs, overstates the

true inflation rate. A recent report estimated that the CPI exceeds the true

inflation rate by about 1 percentage point.17 If the CPI overstates inflation,

then Social Security COLAs increase benefits too much. Moreover, COLAs are

costly. Social Security currently pays about $350 billion in benefits;

therefore, each 1-percent COLA raises outlays $3.5 billion. COLA increases

and any errors in them are cumulative, with each year’s adjustment

compounding the previous years’ adjustments. For the same reason,

however, COLA reductions would have a compound effect on benefits.

Many retirees rely on Social Security COLAs to help keep up with inflation

because most pensions have no inflation adjustments or only partial ones.

Proposals to modify the COLA include the following: making technical

adjustments to the CPI itself; limiting COLAs, for example, by using the CPI

17Advisory Commission to Study the Consumer Price Index, “Toward a More Accurate Measure of the

Cost of Living,” Final Report to the Senate Finance Committee, Dec. 1996.

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Social Security’s Financing Challenges

minus 1 percentage point or capping the COLA at, say, 2.5 percent; delaying

the COLA for a specified number of years or until cumulative inflation

reaches, say, 5 percent since the last adjustment; eliminating the COLA; or

limiting a full COLA to persons with relatively low benefits.

Means-Testing Benefits Means-testing Social Security benefits would also reduce program costs

and direct benefits to persons who need them most. It would reduce

benefits for those with incomes above a certain threshold or from

specified sources, such as other pensions. However, persons losing

benefits would tend to be those who pay the highest Social Security taxes

and already implicitly receive the lowest rates of return on their

contributions. Means-testing would further reduce benefit equity for them

and could diminish whatever political support they give to the system.

Means-testing could raise perceptions of Social Security as a welfare

program rather than a program that ensures a basic retirement income to

persons who work and contribute to the system their entire working lives.

Means-testing could also be applied specifically to dependents’ benefits.18

Social Security provides benefits for spouses and children of retired,

disabled, and deceased workers. For example, eligible spouses currently

receive a benefit based on half the worker’s basic benefit, regardless of the

worker’s benefit amount.

Increasing Income Taxes on

Social Security Benefits

In a sense, income taxes on Social Security benefits already provide a

limited means test. Social Security benefits are subject to income taxes if

current income exceeds $25,000 for a single person or $32,000 for a

married couple. Also, taxes currently apply to only a portion of benefits,

up to 85 percent of them, depending on adjusted gross income. Modifying

these provisions further, by making 100 percent of benefits subject to

income tax above certain income levels, for example, would have an effect

similar to a means-tested benefit reduction.

Increasing Revenues From

Social Security Payroll Taxes

The Social Security payroll tax provides about 90 percent of the system’s

revenue, and increasing the payroll tax rate is the most obvious way to

increase revenues. However, for many people, the Social Security tax is

already the largest tax they pay. According to SSA’s intermediate actuarial

assumptions, increasing the payroll tax rate from 12.4 to 14.6 percent for

1996 and subsequent years would have restored financial balance for the

18In 1995, about 43 million people were receiving Social Security benefits, of which 3.3 million were

spouses, 5.5 million were widows or widowers, and 3.7 million were children. Half of children

beneficiaries were children of deceased workers and more than a third were children of disabled

workers. About 27 million of the beneficiaries were retired workers, and more than 4 million were

disabled workers.

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next 75 years.19 Increasing the payroll tax rate would cause all covered

workers and their employers to pay more taxes, but workers would

receive no increase in benefits from paying these additional taxes. Also, by

reducing workers’ disposable income, such tax increases would make it

more difficult for some workers to save.

Enlarging the Social Security tax base would also increase payroll tax

revenues. For example, the maximum earnings subject to the payroll tax

are $65,400 per year in 1997.20 Increasing the earnings subject to the

payroll tax would increase taxes for a relatively few high earners (about

6 percent of all workers). In addition, about 4 percent of the workforce

remains uncovered, which mostly includes some state and local

government employees and federal employees hired before 1984. Bringing

new state and local workers into the Social Security system would expand

the payroll tax base. However, expanding the tax base also increases

future benefit payments because the newly covered earnings would be

included in benefit computations.

Investing Trust Funds in the

Stock Market

Investing some portion of the Social Security trust funds in the stock

market rather than in government securities might increase system

revenues but has potential drawbacks as well. Historically, stock

investments have earned higher returns on the average than Treasury

securities, but they also carry higher risks. Nevertheless, investing in

stocks could increase program revenues without raising taxes. However,

Social Security would no longer buy as many Treasury bonds, so Treasury

would have to sell more in the private capital market.

As a whole, the federal government would be selling lower-yielding

government bonds and buying higher-yielding private securities. In turn,

such government activity could affect prices of stocks and their expected

returns and interest rates. Also, as partial owners of a company,

stockholders can vote on company policies, which raises the question of

whether and how the government would exercise its voting privileges.

While the funds could be invested in “passively managed” portfolios,

political pressures could also lead the government to select or omit

particular stocks for investment.

19However, each year’s actuarial valuation covers a new 75-year period. Therefore, long-term actuarial

balance can change from year to year.

20The maximum earnings subject to Social Security payroll taxes is updated automatically each year in

proportion to increases in the average annual wage.

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Program Restructuring

Serves Other Objectives as

Well as Long-Term Balance

A variety of proposals would address Social Security’s long-term funding

problems by significantly restructuring the program, usually by privatizing

at least a portion of it.21 Such proposals still essentially achieve financial

balance by, in effect, raising revenues and reducing costs, but they do so in

ways that pursue other objectives as well. Some would reduce the role of

Social Security and the federal government in providing retirement income

and give individuals greater responsibility and control over their own

retirement. Some proposals focus on trying to increase national saving and

funding future Social Security benefits in advance.

Generally, privatization proposals focus on setting up individual

retirement savings accounts and requiring workers to contribute to them.

The accounts usually replace a portion of Social Security, whose benefits

would be reduced to compensate for revenues diverted to the savings

accounts. Some combine new mandatory saving and Social Security

benefit cuts, hoping to produce a potential net gain in retirement income.

The mandated savings deposits and revised Social Security taxes

combined would be greater than current Social Security taxes, in most

cases.

Virtually all proposals addressing long-term financing issues would

increase the proportion of retirement assets invested in the stock market

or in other higher-risk, higher-return investments. The common objective

is to finance a smaller share of retirement costs with worker contributions

and more of the costs with investment returns.

The federal government’s Thrift Savings Plan (TSP) for federal workers

exemplifies how individually held accounts could be invested in the

private sector with a limited government role. Under TSP, vested federal

workers own their savings accounts and choose how to invest them in a

range of passively managed funds, which include funds invested in stocks,

corporate bonds, and government bonds. The government administers

these funds through contractors and delegates proxy voting to them.22

In the case of individually managed savings accounts, the risk of economic

and market performance would be shifted to the worker. Individuals with

21Chile is often cited as an example of how privatization can work. Other countries also have planned

or are planning to privatize their social security systems. However, their macroeconomic situations

and political institutions often differ substantially from ours. For example, Chile is a much less

developed economy than the United States, and when it privatized, it had limited capital markets and a

budget surplus.

22However, the size of such funds under various reform proposals would be far greater than under TSP

and, thus, the voting issue would be magnified.

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identical earning histories and retirement contributions could have

notably different retirement incomes because of market fluctuations or

individual investment choices. Some observers have expressed concern

that many workers lack the knowledge necessary to make the best

investment decisions. Many workers, especially women, invest too large a

portion of their savings in relatively safe, fixed-income securities that earn

a relatively low return and shy away from more “risky” equity investments

that generally earn a higher average return. Proponents of privatization

respond that investor education programs can teach workers how to

manage their investment portfolios better. Limited research indicates that

investor education is effective at increasing both workers’ retirement

contributions and their investment returns. Finally, care must be taken to

ensure that retirement savings would last until the retiree dies. Some

proposals would require retirees to purchase a lifetime annuity with their

retirement savings.

To the extent that privatization requires workers to increase their

retirement saving, it could increase national saving. However, workers

might reduce other saving either because they would have less disposable

income from which to save or because they would, in effect, let the new

retirement accounts substitute for their other saving. In cases in which

privatization largely involves redirecting the Social Security trust funds’

balances into the stock market, whether government directs the

investment or not, national saving would probably not increase

significantly. Any increase in private sector investment could be offset, at

least temporarily, by Treasury’s need to borrow money from the private

sector to replace the funds it currently borrows from the trust funds.

Some of the privatization proposals raise the issue of how to make the

transition to a new system. Currently, each year’s Social Security taxes are

used for the most part to pay for that year’s benefits. Financing retirement

through individually owned savings accounts requires “advance funding,”

or saving this year’s contributions to provide future retirement income.

Social Security would still have to have revenues to pay benefits that

retirees and current workers have already earned. The revenues needed to

fund both current and future liabilities would clearly be higher than those

currently collected.

Privatization would also have a significant effect on the distribution of

retirement income between high and low earners, although advocates

claim that all would still be better off. As described above, the Social

Security benefit formula redistributes income from high to low earners

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Social Security’s Financing Challenges

and tries to balance the program’s goals of providing equitable benefits

while also meeting basic income needs. To the extent that privatization

involves workers’ contributing to their own retirement saving, their

contributions are not available for redistribution. Some privatization

proposals retain some degree of Social Security coverage or at least a

means-tested safety net and therefore permit some redistribution to

continue. In effect, such proposals separate the program’s equity and

adequacy goals.

Privatization proposals also tend to separate retirement benefits from

Social Security’s survivors’ and disability benefits. In the cases of death or

disability before retirement, individual savings may not have been building

long enough to sufficiently replace lost income. Some privatization

proposals, therefore, leave these social insurance programs largely as they

are now. In the case of death after retirement, the surviving spouse and

dependents may still depend on financial support from the retirement

savings of the deceased. Therefore, some privatization proposals would

require retired workers to purchase a joint and survivor annuity with their

retirement savings or obtain spousal consent for the choice of a single life

annuity. Joint and survivor annuities provide lower annual benefits but

continue to pay benefits to the surviving spouses.

Current Proposals Mix

Several Elements

The 1994-96 Advisory Council on Social Security recently issued a report

in which its members offered three alternative reform proposals. While the

council could not achieve majority support in favor of any one proposal, it

did appear to reach agreement on certain points. Some individual

components appeared in more than one of the three proposals:

• extending mandatory coverage to all state and local government workers

hired after 1997;

• assume that revisions to the CPI, which were announced by the Bureau of

Labor Statistics in March 1996, will lower the COLAs for future benefits by

0.21 percentage points;

• increase the number of years of earnings used in computing benefits from

35 to 38;

• subject benefits to income taxes to the extent that workers’ benefits

exceed their contributions and deposit the proceeds in the Social Security

trust funds;

• accelerate the increase in the retirement age, so that the NRA will reach 67

for persons born in 1949 instead of 1960 and increase it after 2011

according to increases in longevity.

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According to the National Academy of Social Insurance, these five

measures combined would eliminate more than two thirds of Social

Security’s long-term financial deficit and postpone the exhaustion of the

trust funds from 2030 to 2052.23

Of the three comprehensive reform proposals, the one called the “maintain

benefits” plan, generally associated with former Social Security

Commissioner Robert Ball, would make the fewest changes to the current

system. The Ball proposal would make all the changes above except for

increasing the retirement age. In addition, it calls for studying the

possibility of investing 40 percent of the trust funds in the stock market by

selecting a portfolio that would track some broad market index such as

the Wilshire 5000. The investments would be passively managed by an

independent board. In addition to these and other changes, the Ball

proposal would achieve long-term balance by increasing Social Security

taxes in 2045 by 1.6 percentage points (0.8 percentage points each for

employers and employees.)

A second proposal, called the “individual account” plan and generally

associated with Council Chairman Edward Gramlich, would make all five

of the changes above. In addition, the Gramlich proposal would gradually

reduce benefits by modifying the benefit formula so that eventually all

benefits would be financed by the current Social Security tax rate. After

completely phasing in this change, benefits would be 17-percent lower for

average earners, with larger reductions for high earners and smaller ones

for low earners. Combined with raising the NRA, the average earner’s

benefits would ultimately decline about 30 percent. To offset these benefit

reductions, the Gramlich proposal would add a mandatory individual

savings account financed by new contributions from workers of

1.6 percent of their covered earnings, starting in 1998. Workers would

choose among alternative investment options administered by a

government board, similar to the administration of the TSP. At retirement,

workers would be required to purchase a lifetime annuity with the money

in these accounts.

The third proposal, called the “personal security account” plan and

generally associated with benefits consultant Sylvester Schieber and

economist Carolyn Weaver, would make the most dramatic changes to

Social Security. The Schieber-Weaver proposal would extend coverage,

23National Academy of Social Insurance, “Advisory Council on Social Security Plans,” Social Insurance

Update, Vol. 1, no. 3 (December 1996).

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Social Security’s Financing Challenges

assume cost reductions from corrections to the CPI, and accelerate the

increase in the retirement age. In addition, it would transform Social

Security into a two-tier system. In the first tier, a basic flat benefit amount

adjusted for years with covered earnings would be paid to all retirees. The

amount would equal about two thirds the current poverty level for a single

elderly person, or $410 per month in 1996. The second tier would be a

personal security account financed by shifting 5 percentage points of the

existing employee tax into those accounts. Workers could invest these

funds in a wide range of instruments but could not withdraw them before

retirement. At the ERA, they could use the funds freely. The transition to

the new system would require new taxes equaling 1.52 percent of covered

payroll, starting in 1998 and lasting 72 years. Not insignificantly, it would

also require additional government borrowing of nearly $2 trillion in 1995

dollars during the first 40 years of the transition.

Social Security Trust

Funds and the Federal

Deficit

As a result of previous financing reforms, Social Security collects more in

revenues than it pays out in benefits each year and builds up substantial

trust fund reserves. This annual excess of revenues over expenditures

lowers the total federal deficit. However, tapping these reserves in the

future to help pay benefits would pose a substantial challenge for the

overall federal budget.

The Social Security trust funds are by law invested in federal government

securities and effectively lend money to Treasury. By investing in Treasury

securities, Social Security reduces the amount that the federal government

must borrow in the private financial markets. Until 2009, Social Security is

expected to collect roughly $30 billion more in cash each year than is

needed to pay benefits. In addition, the trust funds’ interest earnings were

nearly $40 billion last year and will grow as the reserves build up. Treasury

credits this interest by issuing more securities. If Treasury had to replace

borrowing from the trust funds with borrowing in the private market, it

would have to pay this interest in cash. This cash could be borrowed by

selling bonds in the private capital market, but such interest payments

would further add to the overall federal deficit.

Social Security’s excess cash revenues are expected to start falling rapidly

in 2009 and to disappear in 2012, under the trustees’ 1996 intermediate

actuarial assumptions. (See fig. 3.1.) Expenditures will then exceed cash

revenues, and the government’s general fund will have to make up the

difference, in effect repaying Social Security. This will increase the budget

deficit, unless offset by revenue increases or spending reductions. In 2028,

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this amount is expected to reach about $183 billion in 1997 dollars. In that

year, the budget deficit from Social Security alone would equal 1.4 percent

of GDP, which is the same share of GDP as last year’s deficit for the entire

federal budget. The trust funds are expected to be depleted in 2029.

Figure 3.1: Social Security’s Revenues Exceed Expenditures Now but Fall Short Later

1995 2000 2005 2010 2015

-100

-75

-50

-25

0

25

50

Excess Revenue (Dollars in Billions)

Source: 1996 Annual Trustees’ Report and unpublished SSA data.

Solving Social Security’s long-term financing problem will not necessarily

eliminate this budget challenge. Some Social Security reform proposals

would diminish the trust fund build-up and spend-down. However, in any

event, efforts to maintain a stable fiscal policy will depend to some extent

on how this spend-down is addressed.

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Private Pensions and Retirement Saving Can

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While Social Security provides a foundation for retirement income,

increasing private pension coverage and individual retirement saving can

contribute substantially toward meeting the income needs of the elderly

and help increase national saving at the same time. To fulfill their potential

as major retirement income sources, both pensions and savings must be

secure and carefully managed.

The two basic types of pension plans are defined benefit and defined

contribution plans. A defined benefit (DB) pension plan promises the

worker a benefit based on a specific formula linked to the worker’s

earnings and years of employment. The employer, as the plan sponsor, is

responsible for funding the promised benefit, investing and managing the

funds, and bearing the investment risk. In terms of coverage, DB pensions

were the predominant type of employer pension for many years. In 1975,

three fourths of workers covered by a private pension had DB plans.

Under defined contribution (DC) plans, a percentage of pay is contributed

to an account for each worker. While the employer generally makes the

contribution, the increasingly popular 401(k) plans also allow

contributions by workers. Retirement income from DC plans depends on

how much money is deposited and how much the invested funds earn. In

DC plans, the worker bears the investment risk and often controls how the

funds are invested. Because nearly all DC plan benefits are taken

immediately as a lump sum, DC pensions are considered to be more

portable than DB plans, which frequently pay a life annuity at retirement.

Federal Policies

Promote Pension

Coverage and Benefit

Security

The federal government has an interest in promoting pension coverage to

ensure greater retirement income security and to help increase national

saving. Also, the government has assumed the role of helping protect

workers’ legal rights to pension benefits. The Internal Revenue Code and

ERISA define the government’s role, and the Department of Labor (DOL), the

Internal Revenue Service (IRS), and PBGC carry out the laws.

The Internal Revenue Code provides preferential income tax treatment for

pension contributions and for the capital gains on the funds. These tax

preferences have the greatest relevance to employees rather than

employers. For employers, all wages are tax deductible just as pension

contributions are, but employees do benefit from the deferral of income

tax on their pension benefits until they receive them. In particular, the

extension of preferential tax treatment to employee contributions to

401(k) plans has resulted in the substantial growth of these plans. Even so,

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the effect of these tax preferences depends significantly on the structure

of income tax rates. Marginal tax rates on high and middle earners have

dropped considerably since the 1970s. The tax rate on capital gains also

affects these tax preferences because many DB and DC pension assets are

invested in equities and other financial instruments that would otherwise

be subject to the capital gains tax. Also, tax preferences for pensions

result in substantial foregone federal revenues, and the Congress has an

interest in limiting these losses and has at times attempted to target who

benefits from them and how much. Therefore, changes in tax policy could

have a significant effect on pension coverage.

To qualify for preferential tax treatment, pension plans must adhere to

various standards. For example, in 1942, the Congress enacted

“nondiscrimination” provisions to ensure that pension plans did not

receive favorable tax treatment if a disproportionate share of the benefits

accrued to company officers or other highly paid individuals.

In 1974, the Congress enacted ERISA to make pension promises more

explicit and workers’ benefits more secure. Among other things, ERISA

requires that private DB plan sponsors make contributions according to

actuarial standards to help ensure adequate funding. In addition, ERISA

requires such sponsors to pay pension insurance premiums to PBGC, which

assumes the liability for terminated DB plans and pays the retirement

benefits, subject to certain limits. ERISA also requires that plan investments

be diversified and that plan fiduciaries adhere to prescribed standards of

conduct.

More Will Receive

Pensions Although

Coverage Has Not

Grown Recently

Pension coverage for workers in the private sector increased from

15 percent to 45 percent between 1940 and 1970. This expansion resulted

from a variety of factors, including tax preferences, healthy economic

expansion, and the growth of labor unions and also from wage and price

controls during the 1940s and 1950s. Despite wage controls, employers

were able to meet union requests for increased compensation by offering

pensions and other employee benefits. However, since 1970, the coverage

rate has changed very little; it stood at 47 percent in 1993.

Nevertheless, in spite of stagnant pension coverage, more workers

covered under pension plans and their spouses will eventually receive

pensions. ERISA established vesting rules in 1974 and set a 10-year

minimum before employees could vest—that is, earn a legal right to their

pension benefits. In 1986, the rule was liberalized, allowing either a 5-year

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“cliff” or a graded vesting schedule under which participants are

20 percent vested after 3 years and receive an additional 20 percent each

subsequent year until they are fully vested after 7 years. As a result, more

covered employees will meet the vesting requirement, although benefit

levels will reflect the shorter job tenures of the employees affected.

In addition, more women are working, so more retired couples will have

pension income. Also, a larger share of widowed and divorced retirees will

receive pension income from their spouse’s employers because of spousal

notification laws enacted in 1984.24

Economic Considerations

and Regulation Affect

Pension Coverage

Employers offer pensions because they help attract and retain valuable

employees, encourage older workers to retire, and give workers an

additional incentive to perform well and promote the ongoing success of

the employer. Workers accept pension arrangements in place of higher

wages and, in fact, unions often seek them because workers benefit from

the tax advantages and, with DB pensions, from having employers bear the

risk of long-term commitments (unless and until benefits are distributed as

a lump sum).

However, some factors might make further increases in worker coverage

unlikely. About 60 percent of all older (aged 40 to 60) workers are already

covered. Moreover, employers are less likely to offer pensions if their

workforce tends to be less educated, lower-skilled, or younger or exhibits

high turnover. Only 34 percent of those in their twenties are covered by

pensions. Also, smaller employers are less likely to offer pensions. For

example, only 28 percent of workers at firms with 25-49 employees are

covered, while at firms employing more than 1,000, 67 percent are

covered. Finally, about 9 percent of the workforce is self-employed, and

these workers must, of course, provide for their own retirement income.

Structural changes in the economy also influence employers’ decisions to

provide pensions. In 1945, 35 percent of the workforce, both private and

public, was unionized, compared with 16 percent in 1990, and nearly

80 percent of union workers have pension coverage compared with about

40 percent of nonunion workers. In addition, the rising cost and demand

24The 1984 Retirement Equity Act made the joint-and-survivor benefit the default option for married

workers retiring on a pension. Under the joint-and-survivor option, a surviving spouse will continue to

receive pension benefits once the pension beneficiary dies. To waive this option, both the retiring

worker and his or her spouse must sign a waiver form. Prior to this law, waivers from spouses were

not required, and few retiring workers selected the joint-and-survivor option. As a result, many

spouses were left without pension benefits when the retiree died first.

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for health care has strained the resources that employers have available

for other employee benefits.

Since ERISA was enacted, legislative and regulatory activity regarding

pensions has increased. This activity provided improved benefit security

for workers but has affected the structure of pensions. Some of the

changes have focused on limiting the federal revenues foregone because

of the favorable tax code provisions. However, federal regulations,

especially when they change frequently, tend to increase the cost of

pensions and reduce employers’ incentive to sponsor pension plans.25

Pension Simplification Is a

Focus of Recent

Legislation

In response to concerns about regulatory burdens on employer pension

plans, recent federal initiatives have focused on pension simplification.

These efforts seek to encourage expanded coverage by reducing the

regulatory requirements for small employers to start pensions. However,

this regulatory relief is usually accompanied by a required employer

contribution for all employees that might not be attractive to the small

employer. Past pension expansion efforts along this line, such as

simplified employee pensions (SEP), have not been notably successful in

raising pension plan sponsorship rates.26

The Small Business Job Protection Act of 1996, created a new “savings

incentive match plan for employees” (SIMPLE) for firms with 100 or fewer

workers that do not already offer a pension plan. The plan could be based

on IRA or 401(k) arrangements and, sponsors would be exempt from

certain “nondiscrimination” rules or, under certain conditions, other rules

that might otherwise deter plan sponsorship. An employee could

contribute up to $6,000 yearly, and the employer would have to meet a

matching requirement.27

DC Pension Coverage Has

Grown

Although pension coverage on current jobs has been generally stable

overall, the number of workers participating in DC plans has grown steadily

25Committee for Economic Development, Who Will Pay For Your Retirement?: The Looming Crisis

(New York: 1995).

26See Private Pensions: Changes Can Produce a Modest Increase in Use of Simplified Employee

Pensions (GAO/HRD-92-119, July 1, 1992).

27For more detailed information on the provisions in the bill see James R. Storey, Pension Proposals

for Simplification and Increased Access (Washington, D.C.: Congressional Research Service, July 16,

1996). For another discussion on related proposals advanced by the Clinton administration, see James

R. Storey and Ray Schmitt, Pension Reform: President Clinton’s Proposed Retirement Savings and

Security Act (Washington, D.C.: Congressional Research Service, July 10, 1996).

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over the past 20 years. In 1975, 27 percent of pension plan participants had

DC plans; by 1990, 50 percent had them.28 With this trend, more of the risk

and responsibility for providing pension income is shifting from the

employer to the employee. Recent data and analysis suggest that, rather

than representing replacement of DB plans by DC plans, this trend mainly

reflects that new or additional pension benefits are often offered as DC

plans. Many larger employers supplement their DB plans with DC plans.29

In addition, the relatively faster growth of employment at smaller firms

may help explain the trend toward DC pensions, which are easier for

smaller employers to administer. Between 1980 and 1993, the number of

employees in firms with fewer than 100 employees grew 30 percent, twice

as fast as for firms with 500 or more employees. In 1993, small firms

accounted for 56 percent of all employees. About 25 percent of full-time

employees in small firms participate in DC plans, compared with 12 percent

participating in DB plans.

The 401(k) plan is the fastest growing type of DC pension that allows

employees to make tax-deferred contributions that may be augmented by

the employer. The growth of these accounts has contributed substantially

to the DC trend. Between 1984 and 1990, 401(k) plans’ share of all private

plans grew from 3 to 14 percent, and their share of all active pension plan

participants grew from 19 to 46 percent.30 This growth appears to be

continuing.

Efforts to Increase

Personal Retirement

Saving Have Not Been

Successful

Personal savings outside pension arrangements can contribute

substantially to retirement income. However, saving patterns vary

considerably among families. While most families say they recognize the

need to save for retirement, many do not save in any systematic way. As

with pension coverage, government efforts to encourage more personal

retirement saving seem to have had only marginal effects.

According to our analysis of the University of Michigan’s Health and

Retirement Survey, the average net worth of families whose heads are

nearing retirement age (from 55 to 61 years of age) is almost $250,000.

However, the distribution of wealth is uneven, and many families near

28Percentages are not adjusted for double counting of individuals participating in more than one plan.

For a more recent analysis of defined contribution plans see Private Pensions: Most Employers That

Offer Pensions Use Defined Contribution Plans (GAO/GGD-96-181, Oct. 3, 1996).

29Employee Benefits Research Institute, “Pension Evolution in a Changing Economy,” Special Report

and Issue Brief No. 141, Washington, D.C., Sept. 1993.

30401(k) participants may participate in one or more additional plans.

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retirement have relatively few retirement savings. According to our

analysis, over half of these families have less than $100,000 in assets, and

25 percent have less than $25,000 in assets. Over one quarter of families

near retirement in this survey do not own their own home, almost

60 percent have no IRA, over 70 percent do not own stocks, 92 percent do

not own bonds, and half have less than $5,000 in bank accounts.

Tax policy affects how people save for retirement, but its effect on the

overall level of personal saving is less clear. Since the 1970s, federal laws

have granted favorable tax treatment to IRAs and to the closely related

401(k) pension plans. In 1981, most constraints on IRAs were lifted so that

nearly all workers and their spouses could participate, making this form of

tax-deferred saving very popular. After 1986, tax policy limited the group

of workers who could make tax-deductible IRA contributions. Total

contributions fell by more than 60 percent, and the percentage of all tax

returns claiming an IRA deduction fell from 16 percent in 1985 to 6 percent

in 1988. Recent polling evidence suggests that people would save more in

IRAs if the tax benefits were increased. The 401(k) plan has many of the

same tax advantages as IRAs and is now the fastest growing type of pension

plan.

Preferential tax treatment for IRAs and 401(k) accounts seems to

encourage saving in these vehicles, but they may not necessarily represent

totally new saving. Some contributions may merely have been shifted from

other forms of saving. Between 1970 and 1994, personal saving rates

declined from roughly 8 to 4 percent of disposable personal income, even

with these retirement saving incentives. Also, according to available data,

most persons responding to these tax preferences are middle- to

upper-income, not lower-income, who receive very little income from

retirement savings. Low-income families may find it especially difficult to

save, and most public assistance programs penalize private saving by

requiring low levels of financial assets in order to qualify.

Will Pensions and

Savings Be There for

Retirement?

To fulfill their potential as retirement income sources, pension assets and

savings must be preserved and carefully managed. ERISA sets out

requirements regarding how pension assets must be managed, invested,

and preserved for retirement. While tax rules discourage using pension

assets for nonretirement purposes, they do not prohibit such use entirely.

Also, many pensions allow workers to take a lump sum at retirement

rather than receive an annuity. If they elect to take a lump sum, retirees

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must then carefully manage these assets along with their other savings to

make them last throughout their retirement.

Protecting DB Plan Assets PBGC insures and guarantees DB pension benefits, and IRS monitors plan

funding status. Funding requirements aim not only to protect workers’

pensions but also to limit PBGC’s risk of assuming financial responsibility

for unfunded benefits when employers go out of business. Premiums for

pension guaranty insurance are set so that they increase as the extent to

which the plan is underfunded increases. Underfunded plans may also be

required to make contributions that gradually reduce the plan’s unfunded

liability. Recently, the Retirement Protection Act of 1994 revised rules

relating to pension plan underfunding. Along with the healthy investment

returns that pension funds have enjoyed, such reforms have substantially

improved funding levels and have reduced the financial risk to the pension

sponsors that pay the PBGC insurance premiums. Under current law, PBGC

may borrow up to $100 million from Treasury, but the federal government

has no legal obligation to back up PBGC otherwise.

For well-funded plans, boosted by the strong stock market performance of

the 1980s and 1990s, the issue arises of how to deal with overfunding.

Since firms own the pension assets, they sometimes want to take some of

the excess assets back and use them elsewhere. The courts have upheld

plan sponsors’ right to “revert” assets, and the practice may be consistent

with prudent plan funding. Still, the Congress has been concerned that

such reversion may threaten benefit security if the sponsors or their

pension funds do poorly in the future. The Congress imposed substantial

penalties in response to a wave of reversions in the 1980s, largely stopping

the practice. As recently as 1995, proposals were offered to loosen these

restrictions.

Investing and Preserving

DC Plan Assets

With DC pensions, as well as with individual retirement saving, workers

generally have responsibility for directing how their assets are invested.

Some invest conservatively and earn low returns even though they still

have many years before retirement and could arguably bear the risks

associated with higher-return investments. To help expand workers’

investment choices, DOL recently issued an interpretive bulletin regarding

the 404(c) rules to clarify the kinds of investment information firms can

give their workers without being professionally liable for giving

investment advice.

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Workers also diminish their DC pension savings when they use the funds

for nonretirement purposes. Most plans allow participants to borrow from

their accounts for nonretirement expenditures such as purchasing a home

or paying educational or emergency expenses. Overall, more than

75 percent of workers with DC pensions are able to borrow from their

retirement accounts. Of these workers, almost 8 percent have outstanding

loans, with an average balance of $3,000. A recent Clinton administration

proposal would allow early, penalty-free IRA withdrawals for selected

expenses. This added liquidity may actually encourage more pension

saving. Still, if workers do borrow, they may reduce the savings available

for retirement.

At retirement, IRA and DC pensions do not have to be taken in the form of

an annuity and are generally taken as a lump-sum amount. Moreover,

about 33 percent of DB plan sponsors, who covered more than half of all

participants, provided a lump-sum option for retiring workers. Annuities

help insure retirees against living longer than their retirement funds would

last, but retirees pay insurers for assuming this risk. In contrast, without

an annuity, retirees assume much of the risk for their longevity as well as

responsibility for their wise use of the funds. However, since the federal

and state governments provide public assistance benefits for the

low-income elderly, they also assume some of this risk.

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Concluding Observations

Dramatic growth in our nation’s elderly population raises issues not just

for the future of retirement income but also for the federal budget and for

the economy as a whole. The elderly will consume an increasing share of

the nation’s output, and unless retirement or work patterns change,

relatively fewer workers will be supporting more retirees. Our analysis

leads us to five observations about the future direction of federal

retirement income policy.

First, if the dominant purpose in examining Social Security is to restore

long-term financial balance to the Social Security system, then some

combination of traditional adjustments —revenue increases or benefit

reductions —could be sufficient. However, some observers believe that

the structure of this program should be reevaluated in light of the

economic, political, and demographic changes of the past 60 years. Even

though Social Security has become the most important single source of

retirement income for many people, many believe that now is an

appropriate time to assess whether the current structure of benefits best

serves today’s retirement needs.

Second, giving people greater responsibility for their retirement income

and greater opportunity to invest their savings to earn potentially higher

rates of return might raise the general welfare of the nation’s elderly

retirees. But such potential gains must be weighed against the potential

problems associated with having individuals bear much more of the risk in

saving for retirement. Also, if the Social Security program is to continue to

play an important role in ensuring that the less-well-off have a basic

retirement income, then care must be taken to ensure that changes in the

Social Security program do not exacerbate the condition of particular

groups of elderly poor. Unmarried women are currently much more likely

to have incomes below the poverty line than other beneficiaries. Changes

such as increasing the number of years used in computing benefits would

disproportionately affect women because they more often already have

several years of zero earnings included in the benefit calculation. Such

distributional effects will have to be considered in any reform proposal.

Third, while Social Security’s long-term financing problem and the federal

budget deficit are different issues, the practice of using the Social Security

trust funds’ surpluses to partially offset the deficit elsewhere in

government has substantially intertwined the two issues. The program’s

annual cash surplus is projected to start falling by 2009 and to disappear

entirely in 2012, under Social Security’s intermediate assumptions. As

payments to beneficiaries begin to exceed cash receipts, Social Security

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Concluding Observations

will have to redeem the Treasury certificates it now holds. Redemptions

will reach nearly $200 billion annually in 2028 (in 1997 dollars) and will

place significant strains on the federal budget. Moreover, some of the

proposals to privatize Social Security involve heavy additional federal

borrowing to finance the transition from a pay-as-you-go to a partially or

fully funded system. All proposals will have to be examined not only for

their effect on Social Security but also for their overall budgetary

consequences.

Fourth, to respond to the nation’s retirement income challenges

effectively, we must also examine pensions and private savings and the

potential effect of Social Security reform proposals on them. For example,

raising Social Security taxes could make it more difficult for people to

save for their retirement or to contribute to their pensions. Proposals to

solve Social Security’s long-term financial problem will have to take into

account the effect on achieving our goals of encouraging greater employee

participation in pensions and increased rates of national saving.

Finally, some of the Social Security privatization proposals focus on

increasing the national rate of saving. If successful, these changes could

help raise our standard of living and help mitigate the strain from dealing

with Social Security’s financing problem. Increased national saving could

lead to higher rates of economic growth, which, in turn, would make it

easier to meet the financial challenges posed by the shortfalls in Social

Security. However, raising the national saving rate may prove to be

difficult. The proposals that aim to increase national saving through

creating individual retirement savings accounts cannot guarantee that

these savings will not simply substitute for other forms of saving. In

addition, some of the proposed changes to the nation’s retirement system

could have significant effects on the nation’s equity and bond markets, and

this will have to be evaluated before such changes are adopted.

Ensuring that Americans have enough retirement income in the

twenty-first century to meet their needs will require that the nation and the

Congress make some difficult choices. Social Security has been an

effective agent for ensuring a reliable source of income in retirement and

greatly reducing poverty among the elderly. The effect of changes to the

system on other retirement income sources and their effects on various

groups within the aged population should be well understood before

decisions are made. Further, the interplay of budget and saving effects will

have to be carefully considered before any reform proposal is adopted.

Page 51 GAO/HEHS-97-81 Retirement Income Issues
Appendix I 

Major Contributors to This Report

Francis P. Mulvey, Assistant Director, (202) 512-3592

Ken Stockbridge, Evaluator-in-Charge

Michael Packard, Economist

Ken Bombara, Economist

Thomas Hungerford, Economist

Alicia Cackley, Economist

Page 52 GAO/HEHS-97-81 Retirement Income Issues
Page 53 GAO/HEHS-97-81 Retirement Income Issues
Page 54 GAO/HEHS-97-81 Retirement Income Issues
Page 55 GAO/HEHS-97-81 Retirement Income Issues
Related GAO Products

Social Security Reform: Implications for the Financial Well-Being of

Women (GAO/T-HEHS-97-112, Apr. 10, 1997).

Private Pensions: Most Employers That Offer Pensions Use Defined

Contribution Plans (GAO/GGD-97-1, Oct. 3, 1996).

401(k) Pension Plans: Many Take Advantage of Opportunity to Ensure

Adequate Retirement Income (GAO/HEHS-96-176, Aug. 2, 1996).

Public Pensions: Section 457 Plans Pose Greater Risk Than Other

Supplemental Plans (GAO/HEHS-96-38, Apr. 30, 1996).

Social Security: Issues Involving Benefit Equity for Working Women

(GAO/HEHS-96-55, Apr. 10, 1996).

Public Pensions: State and Local Government Contributions to

Underfunded Plans (GAO/HEHS-96-56, Mar. 14, 1996).

Federal Pensions: Thrift Savings Plan Has Key Role in Retirement Benefits

(GAO/HEHS-96-1, Oct. 19, 1995).

Private Pension Plans: Efforts to Encourage Infrastructure Investment

(GAO/HEHS-95-173, Sept. 8, 1995).

Private Pensions: Funding Rule Change Needed to Reduce PBGC’s

Multibillion Dollar Exposure (GAO/HEHS-95-5, Oct. 5, 1994).

Pension Plans: Stronger Labor ERISA Enforcement Should Better Protect

Plan Participants (GAO/HEHS-94-157, Aug. 8, 1994).

Private Pensions: Changes Can Produce a Modest Increase in Use of

Simplified Employee Pensions (GAO/HRD-92-119, July 1, 1992).

Pension Plans: Survivor Benefit Coverage for Wives Increased After 1984

Pension Law (GAO/HRD-92-49, Feb. 28, 1992).

Social Security: Analysis of a Proposal to Privatize Trust Fund Reserves

(GAO/HRD-91-22, Dec. 12, 1990).

Social Security: The Trust Fund Reserve Accumulation, the Economy, and

the Federal Budget (GAO/HRD-89-44, Jan. 19, 1989).

(207444) Page 56 GAO/HEHS-97-81 Retirement Income Issues
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