SOCIAL SECURITY

Capital Markets and

Educational Issues

Associated With

Individual Accounts

United States General Accounting Office

GAO Report to the Chairman,Committee on

Ways and Means

House of Representatives

June 1999

GAO/GGD-99-115

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD-99-115 Issues Associated With Individual Accounts

B-281161

June 28, 1999

The Honorable Bill Archer

Chairman, Committee on Ways and Means

House of Representatives

Dear Mr. Chairman:

Proposals have been advanced by various groups calling for individual accounts as a

component of Social Security reform. To better understand the potential implications of

individual accounts, you asked us to provide you with information on how such accounts

could affect private capital and annuities markets as well as national savings, and to

determine the potential risk and returns to individuals under such a program. You also asked

us to determine the disclosure and educational efforts needed to inform the public about

individual accounts. This report responds to your request.

We will provide copies of this report to the Honorable Charles B. Rangel, Ranking Minority

Member of the House Committee on Ways and Means; the Honorable Kenneth S. Apfel,

Chairman of the Social Security Administration; the Honorable Arthur Levitt, Chairman of the

Securities and Exchange Commission; the Honorable Alexis M. Herman, the Secretary of the

Department of Labor; the Honorable Robert E. Rubin, the Secretary of the Treasury; and

other interested committees and organizations. Copies will be made available to others upon

request.

If you have any questions, please call me (202) 512-8678. Major contributors are

acknowledged in appendix II.

Sincerely yours,

Thomas J. McCool

Director, Financial Institutions

 and Markets Issues
Executive Summary

Page 2 GAO/GGD-99-115 Issues Associated With Individual Accounts

The Social Security program faces a financing challenge primarily due to

the aging of the U.S. population. In response, some reform advocates have

suggested the use of individual investment accounts as a component of

Social Security reform. To better understand the potential implications of

individual accounts, the House Committee on Ways and Means asked GAO

to determine how such accounts could affect (1) private capital and

annuities1

 markets as well as national savings,2 (2) potential returns and

risks to individuals, and (3) the disclosure and educational efforts needed

to inform the public about such a program.

This report addresses certain aspects of the broad issue of the relationship

between individual accounts and Social Security’s long-term financing

needs. It does not seek to evaluate any specific Social Security reform

proposal or seek to address the administrative costs or implementation

issues associated with individual accounts.3

 Rather, to identify the

potential impact of individual accounts on the capital markets, GAO

focused on the potential effect of proposals in which some percentage of

taxable payroll or other potential base would be provided to individuals to

invest in private markets.4

 Some proposals allow individuals wide latitude

in investment options; others provide a narrower choice, generally

between debt and equity mutual funds, or particular types of mutual

funds.5

Individual investment accounts could affect the capital markets in several

ways, depending on how the accounts are funded, how the funds are

invested, and how people adjust their own savings behavior in response to

individual accounts. As a source of funds for the accounts, most proposals

use either the cash collected from Social Security taxes or federal general

 

1

 Annuities are contracts to provide periodic pay-outs for an agreed-upon span of time in return for a

premium. These contracts basically convert savings into income.

2

 National savings includes the savings of individuals, households, and businesses, called private

savings; and the net savings of all levels of government.

3

 GAO has issued two other reports that provide additional information on individual accounts as a

component of Social Security reform. One report provides information on the implementation issues

of individual accounts Social Security Reform: Implementation Issues for Individual Accounts

(GAO/HEHS-99-122, June 18, 1999). The other report provides additional detail on administrative

costs, which can have a direct effect on how much savings are accumulated in individual accounts over

time Social Security Reform: Administrative Costs for Individual Accounts Are Hard to Predict

(GAO/HEHS-99-131, June 18, 1999).

4

 We use 2 percent of taxable payroll as an example throughout the report although, depending on the

proposal, the percentage or the base could be different.

5

 Mutual funds pool the limited funds of small investors into large amounts, thereby gaining the

advantages of large-scale trading. Investors are assigned a prorated share of the total funds according

to the size of their investments.

Purpose

Results in Brief
Executive Summary

Page 3 GAO/GGD-99-115 Issues Associated With Individual Accounts

revenues. As a result, the primary capital market effect is a purely

financial one: borrowing in the Treasury debt market (or retiring less debt)

to provide funding for investment in private debt and equity markets.

Although the annual flows are likely to be sizeable (for instance, 2 percent

of payroll would be about $70 billion in 1998), both the private debt and

equity markets should be able to absorb the inflow without significant

long-term disruption. There could eventually be a significant increase in

the amount of new funds flowing into the annuities market. However, the

magnitude of annuity purchases is likely to build gradually over time as

more retirees build larger balances, allowing the market sufficient time to

adjust.

In addition to the financial effect of redirecting funds from the Treasury

debt market to private capital markets, individual account proposals could

also affect the level of financial resources available for private investment

by increasing or decreasing national savings. The extent to which

individual accounts affect national savings will depend on how they are

financed, the structure of the program, and any behavioral responses of

businesses and individuals. National savings is more likely to increase if

(1) the government funds would have been spent but instead are not; (2)

the program is mandatory and prohibits pre-retirement distributions;6

 and

(3) households do not fully adjust their other retirement saving--that is,

reduce it because of savings involved in individual accounts.

To the extent that households use the opportunities offered by an

individual account program to invest in private equities and debt rather

than Treasury securities, they could increase both the returns they receive

and the risks they face compared to the current Social Security program.

Although asset diversification offers mitigation against certain risks, the

returns that individuals receive would depend on and vary with their

investment choices and the performance of the private debt and equity

markets. On the basis of historical data, most advocates of individual

accounts state that the expected future returns on private investments,

especially equities, would be much higher for individuals than the implicit

return available under the current Social Security program. Others are

skeptical about these claims for higher expected returns on equities. Some

argue that historical returns may not be a good predictor of future returns.

Others suggest that because equity market returns are more volatile than

returns on Treasury securities, a better comparison would be among risk

 6

 Pre-retirement distribution refers to distributions other than the those that would occur as a result of

someone’s death. Some proposals allow distributions at death to be paid as a survivor benefit while

others do not.
Executive Summary

Page 4 GAO/GGD-99-115 Issues Associated With Individual Accounts

adjusted returns of various assets. There are numerous ways to adjust

returns for risk but no clearly best way. In the end, even informed choices

among potential investments depend upon an individual’s tolerance for

risk.

To provide participants with a clear understanding of the purpose and

structure of an individual account program, an enhanced educational

program would be necessary. At a minimum, such a program would have

to provide individuals with information adequate for their decisionmaking,

as well as protect against misinformation. Existing disclosure and

antifraud rules provide for the disclosure of information material to

investors making investment decisions. However, disclosure alone would

not enable participants in an individual account program to make

thoughtful and informed investment decisions. An enhanced and broadbased educational effort would have to be undertaken in order to provide

individuals with information they need and can readily understand as well

as with tools that can help to improve both the decisionmaking process

and awareness of the consequences of those decisions. Individuals would

need education on the benefits of saving in general, the relative risk-return

characteristics of particular investments and how different distribution

mechanisms can affect their retirement income security. If only a few

well-diversified investment choices are provided, most of the educational

effort could be targeted to clarifying the purposes of investing and the

potential long-term consequences of different investment alternatives.

However, if a wide variety of choices is offered individuals so that they

could potentially choose less diversified investments, such as individual

equities, a more broad-based educational program will be necessary.

In early 1997, the Advisory Council on Social Security reported on Social

Security’s long-term financing problem of keeping the program solvent.

Three plans or proposals were advanced by different groups of Council

members. Two plans called for the creation of mandatory individual

accounts, and the remaining plan called for having the government invest

the trust fund in marketable securities.7

 A number of other proposals

calling for individual accounts have been advanced by various research

organizations, academics, and Members of Congress. For the most part,

these other proposals contain provisions similar to those found in the

Advisory Council’s report.

 7

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

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

Background
Executive Summary

Page 5 GAO/GGD-99-115 Issues Associated With Individual Accounts

An individual account program requires that some portion of workers’

contributions to Social Security be put into individual accounts that they

may invest in private equity or debt markets.8 The current Social Security

program is a pay-as-you-go program whereby each year’s revenue is

collected to pay for that year’s benefits. An individual account program

would enable individuals to build up and maintain account balances that

would provide financing for some part of their Social Security retirement

income. As a result, it moves away from a strictly pay-as-you-go system in

the direction of an advanced funded system.

Individual account proposals are usually framed by three characteristics.

The first characteristic pertains to whether to “carve-out” a portion of

Social Security’s tax that is to be invested in financial assets, or to “add-on”

a percentage to the current tax that is to be invested in financial assets.

The second characteristic concerns whether to make investments in

individual accounts mandatory or voluntary. Mandatory participation

would require that each individual invest some percentage of his or her

payroll tax contribution in financial assets. Voluntary individual accounts

would allow individuals to opt in or out of investing any portion of their

payroll tax contributions into financial assets. The third characteristic

pertains to how the accumulated earnings in individual accounts would be

paid out upon retirement, i.e., whether annuitization or a lump sum pay-out

would be required.

Funding of individual accounts will come directly or indirectly from

increased government borrowing, unless funded by a tax increase or

reduced government outlays. In the absence of a tax increase, the

government will need to raise resources either by borrowing in the market

or by not retiring as much maturing debt as it otherwise would. Some part

of funds could be invested in the corporate equity and debt markets. The

amounts that would flow into these markets would depend upon the

options available to individuals as well as the choices they make. The

annual flow resulting from 2 percent of payroll would have been about $70

billion in 1998 dollars. Annual net purchases and sales of equities were

about $300 billion in 1996 and close to half a trillion dollars in 1997 and

1998. Thus, the additional annual flows could represent a 10- to 20-percent

 

8

 Debt and equities are often the benchmarks used, even though eligible market investments could

encompass a wider range of financial assets under certain proposals.

Principal Findings

Market Effects
Executive Summary

Page 6 GAO/GGD-99-115 Issues Associated With Individual Accounts

increase in the annual flow but would still be relatively small compared to

the $15 trillion U.S. equity markets as a whole. Funds flowing into

individual accounts are more likely to have some short-term effects on the

corporate bond market because this market is smaller than the equities

market and less liquid—it is not as easy to buy and sell bonds without

moving the market. However, it is unlikely that there will be any

significant long-term disruptions of either market. Moreover, insurance

industry officials said that the annuities markets are likely to be able to

absorb the flows from mandatory or voluntary annuitization. They said

that the annuities resulting from the liquidation of the individual accounts

would generally be phased in over a long period of time and, therefore,

could be absorbed by the market without difficulty.

The extent to which individual accounts would affect national savings

depends on how they would be financed. For instance, funds could come

from (1) within the current Social Security system, which would likely

reduce government savings; (2) a change in the system resulting from

increased payroll taxes or reduced benefits, which would not affect

government savings; or (3) outside the system using general revenues,

where the effect on government saving would depend on how those funds

would otherwise have been used.9

 National saving would also be affected

by how households and businesses respond to individual accounts. The

extent of these behavioral effects would depend in part on the structure of

the individual account program and any limitations placed on the use of

funds. For instance, proposals that are mandatory are more likely to

increase private saving because such a program would require that all

individuals, including those who do not currently save—such as many lowincome individuals or families—place some amount in an individual

account. Prohibitions or restrictions on borrowing or other forms of

preretirement distributions could also limit the ability of some households

to reduce their savings in response to individual accounts.

Investing in assets through individual accounts involves a trade-off: greater

returns are possible, but only if the individual accepts some additional risk,

including, but not limited to, more variability in rates of return. Under the

current Social Security program, there is little investment risk.

Demographic and economic risk are borne collectively by taxpayers and

beneficiaries. Moving to an individual account program would mean that

 

9

 The primary determinant is what would have been done with the revenue if it had not been used to

finance individual accounts; would the government have spent it, provided tax cuts, or saved it by

buying back outstanding debt? If the government would have spent it or reduced taxes but does not

because it funds individual accounts instead, government saving is not affected. If it would have used

the funds to buy back debt, government saving is reduced.

Expected Returns and Risks
Executive Summary

Page 7 GAO/GGD-99-115 Issues Associated With Individual Accounts

individuals would be able to reap the rewards of their own investments,

but they also would incur risk—not only the possibility of lower returns,

but also the possibility of losing money. Diversification and other asset

allocation approaches could help to improve an individual’s risk/return

trade-off.10 Holding assets for long periods of time could also improve an

individual’s risk/return trade-off because the risk averages out over time,

evening out the variations in risk. However, individuals who retire at the

same time may receive different pay-outs from individual account

investments because of the investment choices they have made. Returns

could also vary depending on when an individual retires because of the

volatility of the stock market. Thus, market-driven results can produce

“winners” and “losers,” depending on when and how individuals invest

their accounts and when they liquidate their holdings. As long as

individuals are aware of and accept this risk, there may not be calls to fix

the “unfair benefits outcomes.” On the other hand, if there are enough

“losers,” there could be calls to offset some or all of any losses.

Advocates and opponents of individual accounts have estimated what the

market rate of return could be for an individual’s investments under an

individual account program. Higher returns are possible for individuals

investing through individual accounts than are possible under the current

Social Security program, but only if individuals take on more risk.

Individuals should therefore not only be interested in the returns from

their investments, but also in the risks that must be incurred to achieve

higher returns. The difficulty is how to measure risk and how to adjust

rates of return to compensate for risk and allow for comparability. There

are many ways to adjust returns for risk but no clearly best way.

Existing Securities and Exchange Commission (SEC) disclosure rules

require that material information be provided about a particular

investment instrument and its issuer. Separate disclosure rules

promulgated by the Department of Labor (DOL) apply to pension plans.

Such disclosure would be essential to an individual account program, with

some rules having more significance than others, depending on the

investment choices offered. For example, if participants were allowed to

acquire individual corporate securities such as stocks and bonds, the

disclosure and reporting requirements of the Securities Acts of 1933 and

1934, such as those applicable to the governance, activities, and financial

status of the issuer, would be particularly important. If investment choices

 10 Diversification refers to investing in more than one asset. Asset allocation is the choice of how much

to invest in each of the broad asset classes—stocks, bonds, cash, real estate, and possibly others to

achieve the best portfolio given the investor’s objectives and constraints.

Enhanced Education
Executive Summary

Page 8 GAO/GGD-99-115 Issues Associated With Individual Accounts

were limited to mutual funds, disclosure about the funds would have

primary importance, while information about the issuers of the securities

owned by the funds would be relatively less significant for participants.

Introducing an individual account program would change the nature of the

current Social Security program and would require increased education,

not only to help people to understand the individual account program, but

also what their responsibilities and risk trade-offs would be. The amount

of education that would be necessary would depend on the range and type

of investment choices and the fees and expenses associated with

individual accounts. As a wider variety of choice is offered to individuals,

especially under a mandatory program, more education beyond the basics

would be necessary because individuals would need to consider broader

issues. In addition to understanding the difference between a stock and a

bond, investors would need to understand the importance of

diversification. Furthermore, being able to understand the rates of return

and various risks of different options and pick the appropriate investment

vehicle becomes more difficult, as more choice is offered. When choices

are limited to a few well-diversified alternatives--such as the case of a few

indexed mutual funds11--many decisions are made by those managing the

funds or are made by rules governing the fund (such as what the funds can

invest in). Thus, if a few well-diversified choices are offered, the individual

would have fewer risk factors to consider, and investor education can be

more targeted. Various officials have suggested that a default option be

provided for those individuals who, regardless of educational effort, would

not make investment choices. Such a default mechanism could provide a

very low-risk option based on Treasuries and/or could gear the asset mix

to the age of the worker.

GAO is not making recommendations in this report.

GAO provided drafts of this report to the Department of the Treasury, the

Social Security Administration, the Securities and Exchange Commission,

and the Pension and Welfare Benefits Administration of the Department of

Labor (DOL) for review and comment. SSA provided written comments

that are included in appendix I. SSA had two major points: (1) that GAO

needed to clarify that comparisons between the rate of return implicit in

the Social Security system and those of individual accounts were

 

11 An indexed mutual fund is a mutual fund that holds shares in proportion to their representation in a

market index, such as the Standard & Poors 500.

Recommendations

Agency Comments
Executive Summary

Page 9 GAO/GGD-99-115 Issues Associated With Individual Accounts

problematic for many reasons, including the fact that Social Security

provides survivors and disability insurance; and (2) that GAO needed to

discuss the savings implications of the President’s proposal. In response

to the first point, we have further clarified issues regarding the rate of

return comparisons. With regard to the second point, this report was not

intended to comment on specific reform proposals.

In commenting on our report, SSA and the other agencies also provided

technical and clarifying comments. We have incorporated these comments

where appropriate.
Page 10 GAO/GGD-99-115 Issues Associated With Individual Accounts

Contents

Executive Summary 2

12

Social Security Has a Financing Problem 12

Individual Accounts Proposed to Help Solve Social

Security’s Financing Problem

13

Objectives, Scope, and Methodology 18

Chapter 1

Introduction

20

Redirection of Funds Could Affect Composition of

Portfolios

20

Current Size of the Private Capital Markets 22

Effect of Individual Accounts on National Savings

Depends on Financing, Structure, and Behavioral

Effects

29

Agency Comments 34

Chapter 2

Capital and Annuities

Markets Able to

Absorb Individual

Account Investments

35

Instituting an Individual Account Program Means Greater

Risk to Individuals for Potentially Greater Return

36

The Expected Market Return for Individual Account

Investments

40

Comparing Rate of Return From Social Security to

Expected Return With Individual Accounts Requires

Careful Consideration

48

Agency Comments 48

Chapter 3

Return and Risks Are

Likely to Be Higher

With Individual

Accounts

50

The Significance of Disclosure Rules Would Depend

Upon Available Investment Choices

51

Enhanced Education Is Necessary for an Individual

Account Program

55

Chapter 4

Enhanced Education is

Necessary for an

Individual Account

Program

Appendix I: Comments From the Social Security

Administration

64

Appendix II: GAO Contacts and Staff Acknowledgments 66

Appendixes
Contents

Page 11 GAO/GGD-99-115 Issues Associated With Individual Accounts

Table 2.1: Amounts of Corporate Equities, Corporate

Bonds, and U.S. Treasuries Outstanding (Dollars in

Billions)

23

Table 2.2: Annual Holdings of Corporate Equities and

Bonds by Various Sectors of the Economy (Dollars in

Billions)

23

Table 2.3: Annual Net Purchases and Sales of Corporate

Equities by Different Sectors (Dollars in Billions)

25

Table 2.4: Annual Purchases and Sales of Corporate

Bonds Equities by Different Sectors (Dollars in

Billions)

26

Table 2.5: Policy Reserves Held for Individual and Group

Annuities (Dollars in Billions)

28

Table 4.1: Investment Choices Under an Individual

Account Program and the Education Required

61

Tables

Figure 3.1: Returns of the Standard and Poors 500 Index 42 Figures

Abbreviations

DOL Department of Labor

FDIC Federal Deposit Insurance Corporation

IRA Individual Retirement Accounts

OASDI Old Age Survivor Disabilities Insurance

OCC Office of the Comptroller of the Currency

OTS Office of Thrift Supervision

SEC Securities and Exchange Commission

SSA Social Security Administration

SPD Summary Plan Description
Chapter 1

Introduction

Page 12 GAO/GGD-99-115 Issues Associated With Individual Accounts

Social Security forms the foundation for our retirement income system. In

1998, it provided approximately $264 billion in annual benefits to 31

million workers and their dependents. However, the Social Security

program is facing significant future financial challenges as a result of

profound demographic changes, including the aging of the baby boom

generation and increased life expectancy. In response, different groups

and individuals have advanced numerous proposals that have called for

the creation of some sort of mandatory or voluntary individual accounts.

To better understand the potential implications of individual accounts, the

Chairman of the House Committee on Ways and Means asked GAO to

determine how individual accounts could affect private capital and

annuities markets as well as national savings, the potential risks and

returns to individuals, and the disclosure and educational information

needed for public understanding and use of an individual account

investment program.

The Social Security program1

 is not in long-term actuarial balance. That is,

Social Security revenues are not expected to be sufficient to pay all benefit

obligations from 1999 to 2073. Without a change in the current program,

excess cash revenues from payroll and income taxes are expected to begin

to decline substantially around 2008. Based on the Social Security

Trustees latest “best estimate” projections, in 2014 the combined OASDI

program will experience a negative cash flow that will accelerate in

subsequent years. In addition, the combined OASDI trust funds are

expected to be exhausted in 2034, and the estimated annual tax income

will be enough to pay approximately 70 percent of benefits.

Every year, Social Security’s Board of Trustees estimates the financial

status of the program for the next 75 years using three sets of economic

and demographic assumptions about the future. According to the

Trustees’ intermediate set of these assumptions (or best estimate), the

nation’s Social Security program will face both solvency and sustainability

problems in the years ahead unless corrective actions are taken. Over the

next 75 years, Social Security’s total shortfall is projected to be about $3

trillion in 1998 dollars.

Social Security’s long-term financing problem is primarily caused by the

aging of the U.S. population. As the baby boom generation retires, labor

 

1

 Social Security consists of two separate trust fund accounts: Old Age and Survivors Insurance

(OASI), which funds retirement and survivor benefits, and Disability Insurance (DI), which provides

disabled workers and their families. These two accounts are commonly combined in discussing the

Social Security program. For the purposes of this report, any reference to the Social Security program

refers to the combined Old Age Survivors Disability Insurance (OASDI) program.

Social Security Has a

Financing Problem
Chapter 1

Introduction

Page 13 GAO/GGD-99-115 Issues Associated With Individual Accounts

force growth is expected to slow dramatically. Beyond 2030, the overall

population is expected to continue aging due to relatively low birth rates

and increasing longevity. These demographic trends will require

substantial changes in the Social Security benefits structure and/or

revenues (i.e., taxes and/or investment returns). Without such changes,

current Social Security tax revenues are expected to be insufficient to

cover benefit payments in about 2014, less than 15 years from now. These

trends in Social Security’s finances will place a significant burden on

future workers and the economy. Without major policy changes, the

relatively smaller workforce of tomorrow will bear the brunt of financing

Social Security’s cash deficit. In addition, the future workforce also would

likely be affected by any reduction in Social Security benefits or increased

payroll taxes needed to resolve the program’s long-term financing

shortfall. As a result, without timely actions, certain generations could

face the twin blows of higher burdens and reduced benefits.

Proposals have been advanced by different groups to reform Social

Security through individual accounts. Such proposals basically also try to

restore the Social Security program’s solvency and conserve its

sustainability. In its report to the Social Security Commissioner, the 1994-

1996 Advisory Council on Social Security offered three alternative reform

proposals, two of which would create individual accounts. The remaining

proposal called for having the government invest the trust fund in financial

assets, such as corporate equities. Numerous other proposals, also calling

for individual accounts, have since been put forth by various organizations.

Currently, therefore, there are a wide array of proposals that rely on some

form of individual accounts. These proposals have in common the idea

that to varying extents, individuals would manage their own individual

accounts. The returns from these accounts would provide some or much

of an individual’s future retirement income.

Social Security is currently structured as a defined benefit program.2

 The

current Social Security program’s benefit structure is designed to address

the twin goals of individual equity and income security—including

retirement income adequacy.3

 The basis of the benefit structure is that

 2

 A defined benefit plan is one in which the employer determines employees’ retirement benefit amount

using specific formulas that consider such factors as age at retirement, years of service, and salary

levels. The employer is responsible for ensuring that sufficient funds are available to pay promised

benefits.

3

 Individual equity means that there should be some relationship between contributions made and

benefits received (i.e., rates of return on individual contributions). Retirement income adequacy is

addressed by providing proportionately larger benefits (redistributive transfers) to lower earners and

certain household types, such as those with dependents (i.e., benefits levels and certainty).

Individual Accounts

Proposed to Help

Solve Social Security’s

Financing Problem
Chapter 1

Introduction

Page 14 GAO/GGD-99-115 Issues Associated With Individual Accounts

these twin goals, and the range of benefits Social Security provides, are

currently combined within a single defined benefit formula. Under this

defined benefit program, the worker’s retirement benefits are based on the

lifetime record of earnings, not directly on the payroll tax he or she

contributed. Alternatively, a number of individual account proposals

introduce a defined contribution structure as an element of the Social

Security program. A defined contribution approach to Social Security

focuses on more directly linking a portion of the worker’s contributions to

the retirement benefits that will be received. The worker’s contributions

are invested in financial assets and earn market returns, and the

accumulations in these accounts can then be used to provide income in

retirement and an additional pre-retirement death benefit. One advantage

of this approach is that the individual worker has more control over the

account and more choice in how the account is invested. In essence, the

defined contribution structure is similar to the current 401(k) or IRA

systems.4

Some proposals combine defined contribution and defined benefit

approaches into a two-tiered structure for Social Security. The aim is to

maintain in some form the current existing system as a base tier and add

an individual account component as a supplemental tier. Some proposals

modify the existing benefit structure; and others propose features that

provide guarantees of current law benefits or some other level, such as the

poverty line. Other proposals have a more complicated formula including

forms of matching. Thus, the relationship between contributions and

benefits may be less direct. Under most of these proposals, individuals

would receive part of their future benefits from a modified Social Security

program and part from the accumulations from their individual account.

Most of the individual account proposals seek to create investment

accounts that to varying extents are managed by the participants

themselves. However, the actual details of how to structure individual

accounts vary by each proposal. Individual account proposals are usually

framed by four characteristics: (1) carve-out versus add-on; (2) mandatory

versus voluntary participation; (3) range of investment options offered;

and (4) distribution options (e.g., required annuitization or lump-sum payout).

 

4

 A 401(k) pension plan is an employer-sponsored defined contribution plan that allows participants to

contribute, before taxes, a portion of their salaries to a qualified retirement account. An IRA is a

personal, tax-deferred retirement account. IRA assets can be invested in almost any kind of financial

instrument.

Four Main Characteristics

of Individual Account

Proposals
Chapter 1

Introduction

Page 15 GAO/GGD-99-115 Issues Associated With Individual Accounts

The first characteristic pertains to whether to carve-out a portion of Social

Security’s tax that is to be invested in financial assets or to add-on a

percentage to the current tax that is to be invested in financial assets.

OASDI has a payroll tax of 12.4 percent. A carve-out involves creating and

funding individual accounts with a portion of the existing payroll tax.

Thus, some portion of the 12.4 percent payroll tax, such as 2 percent,

would be carved out of the existing Social Security cash flow and allocated

to individual account investments. The resulting impact would be that

revenues are taken out of Social Security and less is left to finance current

benefits. Other proposals take a different approach and add-on individual

accounts as a type of supplementary defined contribution tier. For

instance, 2 percent would be added on to the current tax of 12.4 percent.

The resulting effect of an add-on leaves the entire 12.4 percent payroll tax

contribution available to finance the program while dedicating additional

revenues for program financing either from higher payroll taxes and/or

from general revenue.

The second characteristic of individual account proposals concerns

whether to make investments in individual accounts mandatory or

voluntary. Mandatory participation in individual accounts would require

that each individual invest some percentage of his or her payroll tax

contribution in financial assets such as equities. Voluntary participation in

individual accounts could allow individuals to opt in or opt out of investing

any portion of their payroll tax contributions into financial assets.

Individuals would rely on the existing Social Security if they chose to opt

out of participating in individual accounts. Other voluntary approaches

allow individuals to contribute with or without matching to a retirement

account. Additionally, mandatory or voluntary can also refer to the payout an individual receives upon retirement, such as a pay-out in the form of

a lump sum.

The third characteristic has to do with the degree of choice and flexibility

that individuals would have over investment options. Some proposals

would allow unlimited investment choices, such as investments in

corporate equities, bonds, or real estate. Other proposals would offer a

more limited range of choices, such as equity or bond indexed funds.

Thus, individual account investments offer individuals some range of

choice over how to accumulate balances for their retirement.

The final characteristic centers around how the accumulated earnings in

individual accounts will be paid out. Preserving individual’s retirement

income prior to pay-out by prohibiting pre-retirement distributions or

loans is also a requirement of most proposals. However, upon pay-out,

Carve-out Versus Add-on

Mandatory Versus Voluntary

Investment Choices

Annuitization Versus Lump-Sum
Chapter 1

Introduction

Page 16 GAO/GGD-99-115 Issues Associated With Individual Accounts

some proposals would permit requiring annuities--contracts that convert

savings into income and provide periodic pay-outs for an agreed-upon span

of time in return for a premium. Other proposals suggest allowing the

individual to withdraw the account balance in lumpsum or through gradual

pay-outs. 5

Among the changes implementing individual accounts would make to the

current Social Security program is to move away from a pay-as-you-go

system in the direction of an advanced funded system.

Social Security is currently financed largely on a pay-as-you-go basis.

Under this type of financing structure, the payroll tax revenues collected

from today’s workers are used to pay the benefits of today’s beneficiaries.

Under a strict pay-as-you-go financing system, any excess of revenues over

expenditures is credited to the program’s trust funds, which function as a

contingency reserve.

Advanced funding refers to building and maintaining total balances for

Social Security, whether that is done through individual accounts or some

other mechanism.6

 Thus, although individual accounts are a form of

advanced funding, the two terms are distinct. For instance, building up the

balance in the Trust Funds is a form of advanced funding. The creation of

individual accounts refers to a defined contribution system of accounts

connected to Social Security and held in individuals’ names. Essentially,

individual accounts would be advanced funded income arrangements

similar to defined contribution plans or 401 (k) plans. Although privately

held individual accounts are a widely discussed means to achieve

advanced funding, there are other ways to achieve advanced funding.

Another approach to advanced funding using private markets would have

the government invest directly in private capital markets. Building up the

Trust Fund using Treasury securities (marketable or nonmarketable) is

another form of advanced funding, although it does not involve

diversification gains.

Proponents of individual accounts often state that advanced funding and

asset diversification are benefits of their proposals. Yet, although

 

5

 Some other proposals would combine payments from individual accounts with Social Security

benefits into a single benefit.

6

 Advanced funding could also occur through a buildup of nonmarketable or marketable Treasury

securities or through having the government invest in the private sector.

Individual Accounts are

Different From the Current

Social Security Program

Pay-As-You-Go

Advanced Funding Through

Individual Accounts
Chapter 1

Introduction

Page 17 GAO/GGD-99-115 Issues Associated With Individual Accounts

advanced funding, individual accounts, and asset diversification are often

linked, they are conceptually different. Diversification refers to investing

in more than one asset and can be performed by individuals investing in

individual accounts or by the government investing the trust fund in

corporate equities stocks as well as corporate bonds. Any one of the three

categories could change without changing the other. For instance, Social

Security’s Trust Funds are currently invested in nonmarketable

Treasuries.7 Allowing the Trust Funds to invest in assets other than

Treasuries would be diversifying without introducing individual accounts.

Alternatively, individual accounts could be introduced whereby individuals

are allowed to invest in only one asset--thereby introducing individual

accounts without diversifying.

Whether advanced funding through individual accounts increases national

saving is uncertain. The nation’s saving are composed of the private saving

of individuals and businesses and the saving or dissaving of all levels of

government.8

 Supporters of advanced funding point out that individual

accounts offer a way to increase national savings as well as investment

and economic growth. Others suggest that the national saving claims of

those favoring advanced funding through individual accounts may not be

realized. Whether advanced funding through individual accounts increases

national saving depends on a number of factors, including how individual

accounts are financed (existing payroll tax, general revenues); how private

saving9

 responds to an individual account system; the structure of the

individual account system (mandatory or voluntary), and the limitation or

prohibition of pre-retirement distributions and loans to make sure

retirement income is preserved.

Furthermore, even if national saving increases as a result of individual

accounts, individuals may or may not be better off. Saving involves giving

up consumption today in exchange for increased consumption in the

 

7

 The Trust Funds are invested in special issue Treasuries (either bonds or certificates of

indebtedness). These special issue Treasuries are redeemable at face value at any time.

8

 In general, government budget deficits reduce from national savings by absorbing funds that

otherwise could be used for private investment. Conversely, government budget surpluses add to

saving. Surpluses allow the government to pay off some of its maturing debt, thereby reducing the

outstanding level of debt held by the public and freeing up additional funds for private investments.

9

 Private saving is the saving of households and businesses.

Savings Implications of

Advanced Funding
Chapter 1

Introduction

Page 18 GAO/GGD-99-115 Issues Associated With Individual Accounts

future. Some economists have stated that it is not necessarily the case that

all increases in saving are worth the cost of foregone consumption. 10

The Chairman of the House Committee on Ways and Means asked us to

determine how individual accounts could affect (1) private capital and

annuities markets as well as national savings, (2) potential returns and

risks to individuals, and (3) the disclosure and educational information

needed for public understanding and use of an individual account

investment program.

To determine the effect of individual accounts on the private capital and

annuities markets, as wells as risk and return issues, we interviewed

economists and other officials who were both proponents and opponents

of individual accounts. These officials included officials from think tanks

as well as academicians who have studied Social Security reform. We also

reviewed and analyzed several studies relating to the impact of individual

accounts on the market as well as studies that had tried to assess the risks

and return issues that would arise because of individual accounts. We also

analyzed data from the Federal Reserve Flow of Funds as well as data

provided by the insurance industry. Additionally, we talked to industry

officials from both the insurance and securities industries to obtain their

views, and we interviewed government agency officials as.

To determine the disclosure and educational requirements needed, we

spoke to officials from the Securities and Exchange Commission (SEC),

the Department of Labor’s (DOL) Pension and Welfare Benefits

Administration (PWBA), the Pension Benefit Guaranty Corporation, and

the Social Security Administration (SSA). We also spoke to private sector

officials about the educational requirements that would be needed for an

individual account program. Additionally, we reviewed various studies

that have looked at the best ways to educate people about investment and

retirement education.

Because of the wide-ranging nature of the numerous proposals being

advanced, our report focuses on the common, or generic, elements that

underlie various proposals to reform Social Security financing rather than

on a complete evaluation of specific proposals.

 10 See Eric M. Engen and William G. Gale, “Effects of Social Security Reform on Private and National

Saving,” Social Security Reform Conference Proceedings Federal Reserve Bank of Boston, Conference

Series No. 41, June 1997.

Objectives, Scope, and

Methodology
Chapter 1

Introduction

Page 19 GAO/GGD-99-115 Issues Associated With Individual Accounts

We did our work in accordance with generally accepted government

auditing standards between October 1998 and June 1999 in Washington,

D.C., and New York, NY.

We requested comments on a draft of this report from SSA, SEC, DOL, the

Department of Treasury, and the Federal Reserve Board. SSA provided

written comments that are included in appendix I. A discussion of these

comments appears at the end of chapters 2 and 3. SSA and the other

agencies also provided technical and clarifying comments, which we

incorporated in this report where appropriate.
Chapter 2

Capital and Annuities Markets Able to Absorb

Individual Account Investments

Page 20 GAO/GGD-99-115 Issues Associated With Individual Accounts

Individual accounts can affect the capital markets in several ways

depending on how the accounts are funded, how the funds are invested,

how people adjust their own savings behavior in response to having

individual accounts, and the restrictions placed on using funds in

individual accounts for anything other than retirement income. Most of the

proposals use either the Social Security cash flow or federal general

revenues as a source of funds. As a result, the primary capital market

effect is a purely financial one: borrowing in the Treasury debt market (or

retiring less debt) to provide funding for investment in private debt and

equity markets. Although the amounts involved are likely to be sizeable,

the effect would primarily be one of redirecting funds and readjusting the

composition of financial portfolios. There may also be some effect on the

difference between the return on Treasury debt and that paid on riskier

assets, although the effect is not likely to be large. Although substantial

inflows into the private debt market could, in certain circumstances, result

in some increased volatility, both the private equity and debt markets

should be able to absorb the inflows without significant long-term

disruption. There could eventually be a significant increase in the amount

of new funds flowing into the annuities market. However, the magnitude of

annuity purchases is likely to build gradually over time as more retirees

build larger balances, allowing the market sufficient time to adjust.

Another potential effect of individual accounts would be an increase or

decrease in national savings—the overall level of domestic financial

resources available in the economy for the purpose of investing in plant

and equipment. Whether individual accounts would increase or decrease

national savings depends on how they are financed, how private savings

changes as a result of individual accounts, and whether there are

restrictions on households’ ability to borrow.

Most proposals use either the Social Security cash flow or federal general

revenues as a source of funds for individual accounts. The funds raised are

then to be invested in private equity or debt markets. As a result, there

would be an increase in the relative supply of Treasury debt available to

the public and an increase in the relative demand for private debt and

equities to be held in individual accounts. This redirection of funds—

selling Treasury debt for the cash to invest in private debt and equity—is a

purely financial effect. It is likely to result in a change in the composition

of private sector holdings as businesses and households absorb the extra

government debt and provide new or existing private debt and equity,

thereby adjusting their portfolios.

Redirection of Funds

Could Affect

Composition of

Portfolios
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 21 GAO/GGD-99-115 Issues Associated With Individual Accounts

Whether the resources for individual accounts come from Social Security

contributions or general revenues, the level of government debt held by

the public would increase, or not fall as much as it otherwise would. The

only cases in which an increase in debt held by the public would not occur

would be those in which the resources come from an additional source of

funding—either a tax increase, an expenditure reduction, or the result of

some voluntary private saving—that would not otherwise have occurred.

Increased government borrowing from the public could put some upward

pressure on the interest rate at which the government borrows, if private

sector borrowers are to be persuaded to hold the increased supply of

government debt. Funds diverted to private equity and debt markets could

have the effect of raising the prices and therefore lowering the yields

(rates of return) on these higher risk assets. The combined effect could

narrow somewhat the difference between the more risky and least risky

assets.

Whether resources used to finance individual accounts come from new

revenues, additional borrowing, or surpluses, the amounts flowing into

private capital markets are likely to be substantial. Funding of individual

accounts will come directly or indirectly from increased government

borrowing from private markets, unless funded by a tax increase or

spending reduction. To fund most individual account proposals, the

government would need to raise resources either by borrowing in the

market or—under a surplus scenario—by not retiring as much maturing

debt as it otherwise would. For certain proposals, changes in borrowing

may not arise because these proposals rely on a tax increase or benefit

reduction so that current cash flow is not affected. If the source of funding

for individual accounts is a carve-out from the current Social Security cash

flow, this loss in cash flow would have to be made up from increased

borrowing, a reduction in benefits, or some other program change.

Alternatively, if the source of funding is general revenues, either additional

borrowing from the public or less debt retired will be necessary depending

on whether the overall budget is in deficit or surplus.1

 Only if the

government raises taxes or reduces spending, and uses those revenues to

finance individual accounts, is there not likely to be any effect on

borrowing because the remaining cash flow would not be affected.

 

1

 The federal deficit (also called the “unified “ deficit) is the difference between total federal spending

and revenue in a given year. To cover this gap, the government borrows from the public by issuing

securities, mostly through the Treasury Department. A surplus reduces the need for the federal

government to borrow from the public.

Debt Held by the Public Will

Likely Rise to Provide

Funding
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 22 GAO/GGD-99-115 Issues Associated With Individual Accounts

The uses of the funding for individual accounts will depend on the options

available to investors and the choices they make within those options. To

the extent that investors choose to invest in Treasury debt, there is that

much less flowing into private capital markets, and any effects on those

markets would be reduced. However, investors or their agents are likely to

put at least some, if not most, of the funds into the private equity or debt

market, and some proposals call for all of the funds to be invested in

private markets. The size of this potential flow of funds into the private

sector depends on whether individual account investments are mandatory

or voluntary as well as the percentage of payroll that forms the basis for

the program. The actual amounts allocated to private equity and debt will

depend upon individual choice to the extent such choice is allowed, or on

selected percentages if those are set by law.

The initial annual dollar amount flowing into the capital markets as a

result of individual account investments could be about $70 billion (2

percent of payroll) in 1998 dollars. According to our analysis of Social

Security Administration (SSA) data, the effective taxable payroll for all

working individuals will steadily increase well into the future. As a result,

the annual dollar amount from individual account investments is likely to

increase. For instance, our analysis of SSA data indicates that in the year

2020, the effective taxable payroll will be almost $11 trillion. On the basis

of that dollar amount, if 2 percent is the designated percentage, the

amount flowing into the private equity and debt markets from individual

accounts would be about $220 billion in the year 2020.

U.S. capital markets are the largest and most liquid in the world. The total

market value of U.S. equities outstanding at the end of 1998 was about $15

trillion.2

 The total value of corporate bonds3 outstanding in the United

States was about $4 trillion at the end of 1998. The amount of Treasury

debt outstanding was also about $4 trillion. As shown in table 2.1, the

amounts outstanding for corporate equities and corporate bonds have

been increasing. For instance, in 1997 there was about $13 trillion in

equities outstanding, up from $10 trillion in 1996. The amounts outstanding

for corporate bonds has increased from about $3 billion in 1996 to about $4

billion in 1998.

 

2

 This amount also includes foreign issues traded in the United States.

3

 The Flow of Funds data from the Federal Reserve only reports corporate and foreign bonds together.

It is difficult, therefore, to separate the corporate bonds from the foreign bonds, and we did not

attempt to do so. For the purposes of our discussion, we will refer only to corporate bonds.

Funds Would Be Redirected

Into Private Capital Markets

Current Size of the

Private Capital

Markets
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 23 GAO/GGD-99-115 Issues Associated With Individual Accounts

Market 1996 1997 1998

Corporate equities $10,062 $12,776 $15,438

Corporate bondsa 3,128 3,440 3,894

U.S. Treasuries 3,755 3,778 3,724

Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the

fourth quarter 1998, tables L. 209, p. 87, L. 212, p. 89, and L. 213, p. 90.

On the basis of the current size of the corporate equity and bond markets,

the amount representing individual accounts is likely to be a small

percentage of private capital markets, at least for a number of years. For

instance, using a payroll percentage of 2 percent, if $70 billion were to

come from individual accounts, it would represent less than 0.5 percent of

the $15 trillion in equity outstanding in 1998 and less than 2 percent of the

$4 trillion in corporate bonds outstanding in 1998.

Various officials have expressed concern that over time, individual

account investments would represent significant portions of the corporate

equities and bond markets. It is likely that investments from individual

accounts could eventually rival current holdings of other major sectors of

the market and represent a sizeable portion of equity and corporate bond

holdings. For instance, if 2 percent of payroll is placed in individual

accounts annually, SSA estimates that stock holdings in individual

accounts could grow to between $1 trillion and $2 trillion in 1996 dollars

over the next 15 years. The overall market will grow at about the market

rate of return, although individual components may grow faster or slower

depending on strategies and relative demands by mutual funds, pension

plans, and other investors.

Sectors Corporate Equities Corporate Bonds

Year 1996 1997 1998 1996 1997 1998

Mutual funds $1,470 $2,019 $2,523 $230 $274 $339

Private pension plans 1,491 1,864 2,232 228 256 301

State & local governmentsa

956 1,306 1,593 180 200 245

Life insurance companies 410 561 746 949 1,026 1,086

a

State and Local Governments refers to their retirement plans.

Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the

fourth quarter 1998, tables L. 212, p. 89, and L. 213, p. 90.

For instance, as shown in table 2.2, the total value of equity holdings of

mutual funds was $2.5 trillion in 1998, and the total value of corporate and

foreign bond holdings was about $339 billion.4

 The holdings of various

 

4

 Flow of Fund Accounts of the United States, Federal Reserve statistical release for the fourth quarter

of 1998, tables L. 213, p. .90, and L. 212, p. 89.

Table 2.1: Amounts of Corporate

Equities, Corporate Bonds, and U.S.

Treasuries Outstanding (Dollars in

Billions)

Table 2.2: Annual Holdings of Corporate

Equities and Bonds by Various Sectors

of the Economy (Dollars in Billions)
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 24 GAO/GGD-99-115 Issues Associated With Individual Accounts

sectors, such as private pension plans, were about $2.2 trillion of equities

and about $301 billion of corporate bonds in 1998.5

 Thus, although

individual account holdings are likely to increase over time, the holdings of

many other sectors of the economy are also likely to rise, although certain

individual sectors may not. In general, it is difficult to predict how rapidly

the sum of these sectors holdings will grow, especially in the presence of

individual accounts.6

Even if the annual flows from individual accounts into private capital

markets were a small percentage of the total market value of outstanding

debt and equities, these amounts could still represent a substantial

increase in the annual flows into those markets. The actual amounts will

depend on the options available to individuals as well as the choices they

make. If a large percentage of funds from individual accounts flowed into

the equity markets, it could represent an increase of approximately 15 to

20 percent in the flow of funds into and out of the equity market, according

to data from the Federal Reserve Flow of Funds.7

 It is not clear that such

an increase would have much effect on the pricing, or volatility, of the

equity markets. However, the corporate bond market, which is smaller,

could be affected, at least in the short term, depending on how much of the

funds flow into the market and, to some extent, on the timing of those

flows.

Most U.S. equities markets are very liquid—it is easy for investors to buy

and sell equities without moving the price.8

 Various sectors of the

economy, such as the household sector, mutual funds, private pension

plans, and life insurance companies, purchase and sell equities every day.

The equities market is a secondary market in which much of the

transaction volume and value reflects movement of equities between

purchasers and sellers. The annual net purchases can be positive or

negative, reflecting the difference between the value of new equities issued

and the value of equities repurchased; however, the amounts purchased

 

5

 Flow of Fund Accounts of the United States, Federal Reserve statistical release for the fourth quarter

of 1998, table L. 213, p. 90.

6

 See later section of this chapter for a discussion of possible changes in household savings behavior in

response to individual accounts.

7

 This percentage relates approximately $70 billion in individual account funds to the approximately

$400 to $500 billion in net purchases and sales of equities over 1997 and 1998.

8

 The equities markets are said to be “liquid” because the markets attract many buyers or sellers. In a

liquid market selling or buying can be done with minimal effect on the prevailing competitive

established price. The advantage of a liquid market for customers is immediacy or the ability to sell

quickly when the customer needs to or buy quickly when there is a chance to make a profit.

Current Flows Into Private

Capital Markets

Current Stock Market Flows
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 25 GAO/GGD-99-115 Issues Associated With Individual Accounts

and sold by specific sectors can be quite large. For instance, the annual net

purchases of equities were minus $3 billion in 1996, minus $79 billion in

1997, and minus $178 billion in 1998.9

 As can be seen in table 2.3, the three

largest purchasers bought in the range of $300 billion in securities each

year from 1996 to 1998. In terms of sellers, the household sector sold

almost $300 billion in 1996 and about a half of a trillion dollars in both 1997

and 1998.

Sector Corporate equities

1996 1997 1998

Largest net buyers

 Mutual funds $193 $167 $144

 Retirement plans of state and local govts. 52 54 66

 Life insurance companies 42 93 92

Largest net sellers

 Household sector -282 -514 -500

 Private pension plans -10 -16 -53

Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the

fourth quarter 1998, table L. 213, p. 45.

Annual flows within the equities market were in the hundreds of billions of

dollars between 1996 and 1998. Over that period, mutual funds, life

insurance companies, and state and local government retirement plans

were the primary purchasers, and private pension plans and households

were the major sellers of equities. Compared to these annual amounts, an

additional tens of billions of dollars generated by individual accounts is not

likely to cause major disruptions and could potentially be absorbed

without significant price or volatility effects.

There is a greater chance of some possible disruption, however, if all of the

individual account funds were to flow in at once rather than regularly, but

not too predictably, over the course of the year. For instance, $70 billion

distributed evenly over the year would be unlikely to cause much

disruption. However, concentrating that same flow into one quarter of the

year could have some short-term effect on the market because it would

represent a substantial increase in quarterly flows. As a result, to minimize

the likelihood of disruption, it would make sense, to the extent practicable,

to smooth out the inflows so that they do not all come into the market

within a short time period. If the inflows are lumpy and predictable, the

market may be able to anticipate the inflows and adjust prices somewhat,

which could mean that individual account purchases would pay slightly

higher prices than they otherwise would.

 

9

 Flow of Funds Accounts of the United States, Federal Reserve statistical release for the fourth quarter

of 1998, table F. 213, p. 45.

Table 2.3: Annual Net Purchases and

Sales of Corporate Equities by Different

Sectors (Dollars in Billions)
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 26 GAO/GGD-99-115 Issues Associated With Individual Accounts

The corporate debt markets are not as transparent as the corporate

equities markets; for example, there are no central listings for the prices of

the bonds or the volume of corporate bonds sold. They also do not have as

much depth as the equities markets—there are fewer buyers and sellers in

the corporate bond markets. Many corporate bond transactions are done

through private placements; i.e., they are not offered to the corporate debt

market as a whole. The result is a market with less liquidity reflected in a

greater spread between the bid price (what you will pay for the bond) and

the ask price (the price at which you would sell the bond).

As stated previously, the value of outstanding corporate debt is

substantially less than the market value of corporate equities. On an

annual flow basis, corporate debt issues have been running in the

hundreds of billions of dollars over the last decade. However, some

proportion of that is short term (less than 1 year in maturity) so that the

total is not easily comparable to the annual amounts of equities purchased

and sold. As shown in table 2.4, the annual net purchases of corporate

bonds by various sectors ranged from as low as $17 billion for state and

local government retirement plans of in 1996 to as high as $79 billion for

life insurance companies in 1996. On the basis of annual flows, it is

difficult to say what the effect on the bond market is likely to be.

Sector Corporate bonds

1996 1997 1998

Large Buyers

 Mutual funds $34 $44 $65

 Retirement plans of state and local govts. 17 19 45

 Private pension plans 21 28 45

 Life insurance companies 79 77 60

Source: Flow of Funds Accounts of the United States, Federal Reserve statistical release for the

fourth quarter 1998, table F. 212, p. 44.

However, if we compare the corporate bond and equity markets, we can

draw some tentative conclusions about the likelihood of individual

accounts having a disruptive effect on either market. The corporate bond

market is relatively smaller and less liquid than the equity market. As a

result, an inflow into the bond market is more likely to affect the market

price and the volatility of the market, compared to an equivalent inflow

into the equity market, especially if it is concentrated in a short period of

time. Any disruption is still likely to be short term in nature and can be

mitigated if the inflow is spread over time, so that other market

participants are less able to predict the inflows and raise prices in

anticipation of the inflow.

Corporate Debt Flows

Table 2.4: Annual Purchases and Sales

of Corporate Bonds Equities by

Different Sectors (Dollars in Billions)
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 27 GAO/GGD-99-115 Issues Associated With Individual Accounts

Although there are various types of Treasury debt, the overall market for

U.S. Treasuries is far more liquid and transparent than the corporate bond

market. A large secondary market—in which Treasury securities are

bought and sold subsequent to original issuance—exists for Treasuries and

helps to make it one of the most liquid markets in the world. Annual net

purchases of Treasuries were $23 billion in 1997 and minus $55 billion in

1998.10

The effect on the Treasury debt market from a movement to individual

accounts will depend not only on the choices available to individuals but

also on the extent to which the government borrows from the private

capital markets to fund individual accounts. As stated previously, to fund

any individual account proposal that does not increase Social Security

contributions, the government would need to raise resources either by

borrowing in the market or by not retiring as much maturing debt as it

otherwise would. The Treasuries market, therefore, could be affected in

two ways: (1) by how much the government borrows to fund individual

accounts, and (2) by how much individuals choose to invest in Treasuries.

However, the depth and liquidity of the Treasury debt market is such that

the market is unlikely to be significantly disrupted even by a large flow of

funds resulting from individual accounts.

Annuities protect against the possibility of outliving one’s financial

resources by guaranteeing a stream of income for the remainder of one’s

life, regardless of how long that may be. Annuities basically convert

savings into income and may be sold individually or as a group product. In

a group annuity a pension plan provides annuities at retirement to a group

of people under a master contract. It usually is issued by an insurance

company to an employer plan for the benefit of employees. The individual

members of the group hold certificates as evidence of their annuities.

Depending on the structure of individual accounts, individuals may be

required to purchase individual annuities or, similar to pension and other

retirement plans, fall under a group annuity.11

One measure of the size of the annuities market is the level of the

insurance industry’s policy reserves—the sum of all insurers’ obligations to

their customers arising from annuity contracts outstanding. Each company

is required by state insurance regulators to maintain its policy reserves at a

 

10 Flow of Funds of the United States, Federal Reserve statistical release for the fourth quarter of 1998,

table F. .209, p. 42.

11 Some approaches call for having the government be responsible for small annuities. Other

approaches call for individual account accumu.lations to feed into Social Security benefits.

Treasury Debt

Affect of Individual

Accounts on the Annuities

Markets
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 28 GAO/GGD-99-115 Issues Associated With Individual Accounts

level that will ensure payment of all policy obligations as they fall due. As

shown in table 2.5, policy reserves for individual annuities were about $693

billion and for group annuities about $762 billion.

1995 1996 1997

Annuities

 Individual $594 $622 $693

 Group 619 690 762

Source: Life Insurance Fact Book, American Council of Life Insurance, 1998, table 7.5, p.119.

Insurance industry officials told us that the annuities industry is likely to

be able to absorb the flows from either mandatory or voluntary

annuitization. Once again, we are talking about a movement of financial

resources from one form to another rather than a new source of funds. The

funds will be moved out of whatever investment instruments (assets)

workers were using for accumulation purposes into a potentially different

combination of assets held by companies supplying annuities.12 Insurance

industry officials believe that, generally, annuities resulting from the

liquidation of the individual accounts would be phased in gradually and

over a number of decades. In the early years, few if any retirees would

have built up substantial individual account balances. As time passes, both

the number of retirees with individual account balances and the average

size of those balances would gradually increase, allowing the industry and

the market time to adjust without difficulty.

One issue raised by insurance industry officials was that an individual

account proposal that made annuity purchases mandatory at retirement

could result in the demand for a significant number of very small annuities.

For instance, at least initially, there would be many small accounts below

$2,000. Currently, annuity purchases average about $100,000. Although the

industry could absorb a significant number of small accounts, industry

officials said that providing annuities that small could be uneconomical for

the industry because the cost of issuing a monthly check, and other

administrative costs, would be prohibitive.13

 

12 Annuities have traditionally been supplied by life insurance companies and financed primarily by

investments in corporate debt and real estate, although there is also likely to be some investment in

corporate equities and Treasury debt.

13 In a forthcoming report, we will provide a more detailed discussion of the factors that affect the costs

associated with purchasing an annuity and how this cost may factor into a system of individual

accounts.

Table 2.5: Policy Reserves Held for

Individual and Group Annuities (Dollars

in Billions)
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 29 GAO/GGD-99-115 Issues Associated With Individual Accounts

Although the financial effects of individual accounts are an important

consideration, a related but somewhat separate issue is the potential for

individual accounts to increase or decrease national saving. 14 Along with

borrowing from abroad, national savings provides the resources for private

investment in plant and equipment. The primary way in which a movement

to individual accounts could change the overall capacity of the economy to

produce goods and services would be if individual accounts were to lead

to a change in the overall level of national saving. The extent to which

individual accounts affect national saving depends on how they are

financed (existing payroll tax, general revenues)—the effect on

government saving; how private savings—the savings of households and

businesses—respond to an individual account system; the structure of the

individual account system (mandatory or voluntary); and the limitation or

prohibition of the pre-retirement distribution or loans to make sure

retirement income is preserved.

One important determinant of the effect of individual accounts on national

savings is the funding source. There are several possible funding sources,

although most involve a movement of funds from or through the federal

government and each has its own effects on the federal government’s

portion of national saving. For some funding sources these savings effects

are clearer than others. As previously stated, the funds can come from (1)

within the current Social Security system, i.e., the surplus or current cash

flows; (2) a change in the system resulting from increased payroll taxes or

reduced benefits;15 or (3) outside the system using a general fund surplus

or general revenues.

Using either the Social Security surplus or more generally the current

Social Security cash flow is likely to reduce government saving. If part of

the cash flow is diverted to individual accounts but there is no change in

the benefits paid or the taxes collected, the lost cash flow will either result

in a smaller addition to the surplus or be replaced by borrowing. In either

case the result is a reduction in the measured government surplus—the

sum of the Social Security surplus and the general fund surplus—or an

increase in the deficit. From the government’s perspective, its saving has

gone down to provide the resources for increased personal savings

 

14 National saving includes the saving of individuals, households, and businesses, called private saving;

and the net saving of all levels of government.

15 There are also proposals which allow individuals to voluntarily contribute to individual accounts

from their own resources.

Effect of Individual

Accounts on National

Savings Depends on

Financing, Structure,

and Behavioral Effects

Savings Affected by

Funding Source
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 30 GAO/GGD-99-115 Issues Associated With Individual Accounts

through individual accounts.16 This is a case of a carve-out from Social

Security.

If the resources for individual accounts are financed by additional Social

Security taxes or reduced benefits instead, there will be no direct effect on

government savings. The increased outlays for individual accounts will be

offset by higher government revenues or lower government benefit

payments. In the absence of other changes in Social Security cash flows,

government savings remain constant, and any increase in private saving

would be an increase in national saving. This is a case of an add-on to both

Social Security and to the overall government budget.

The most complicated case involves the use of funds that are outside of

the Social Security system but part of the overall government budget.

There are proposals to use the overall budget surplus or general

government revenues as a source of funds for individual accounts.

Although on its face this appears to reduce government savings by the

amount diverted, the actual effect on government savings depends on what

would have been done with the surplus or revenue if it had not been used

to finance individual accounts.

For example, if the resources would have been used to finance additional

government spending, and the diversion of the funds to individual

accounts means that such spending is not undertaken, government saving

would not be reduced by individual accounts. In this case, any increase in

private saving would be an increase in national saving. Similarly, if the

resources would have been used to finance a tax cut, then diverting funds

to individual accounts does not directly reduce government savings if the

tax cut is not undertaken. In the case of a tax cut, national saving will go

up if individual accounts generate more private saving than the tax cut.

If the funds would have been used to pay down debt, the direct effect of

diverting those resources to individual accounts would be to reduce

government saving. The full effect on national saving depends on the

extent to which individuals adjust their own savings behavior. If they do

not adjust, national saving is on balance unaffected. To the extent

individuals or businesses reduce their saving, national saving will fall.

 

16 Because national savings is the sum of government and private saving, the effect of a carve-out

depends on whether private savings goes up by more or less than government savings goes down.
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 31 GAO/GGD-99-115 Issues Associated With Individual Accounts

The effects of various individual account proposals on national saving

depend not only on how the proposals affect government savings but also

on how private savings behavior will respond to such an approach.

Regardless of the financing source, the effect of individual accounts will be

to raise, at least to some extent, the level of personal or household saving

unless households fully anticipate and offset through a reduction in their

own saving. For example, a carve-out from the existing Social Security

cash flow would provide funding for individual accounts for everyone

(under a mandatory approach) or for those who wished to participate

(under a voluntary approach). Such a carve-out is likely to reduce

government saving and raise private saving by an equivalent amount in the

absence of any behavioral effects. If households are forgoing current

consumption by saving for their retirement, then, in response to this

potential increase in future retirement benefits, they may reduce, to a

greater or lesser extent and in various ways, their own savings, including

retirement saving. To the extent that household responses lead to reduced

personal saving, national savings as a whole would fall under a carve-out.

In general, the result would be similar under any proposal that reduced

government saving to fund private saving through individual accounts.

This includes proposals that use general revenues that would have been

saved by the government; i.e., used to reduce the deficit or retire debt

outstanding. The overall level of consumption in the economy is not likely

to change as a result of the movement of funds. Any significant change in

the level of consumption resulting from such proposals would result from

some households reducing their retirement savings to fund consumption

because they now had individual accounts.

The extent of these behavioral effects will depend on the structure of the

program and any limitations that are placed on the use of funds in

individual accounts, such as restrictions on preretirement withdrawals. If

such a program is mandatory rather than voluntary, it is more likely to

affect those households who currently either do not save or do not save as

much as the amounts in their individual accounts. A mandatory program

would increase savings for those who do not usually save, who are usually

low-income people.

Household behavior in response to individual accounts will depend on the

extent that the household is currently saving for retirement and how the

set of options available to households is changed by the presence of

individual accounts. One group of households, those that are currently

saving as much as they choose for retirement, given their income and

wealth, would probably reduce their own saving in the presence of

Behavioral Effects Are

Difficult to Predict

Behavioral Change Depends

on Preferences and

Opportunities
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 32 GAO/GGD-99-115 Issues Associated With Individual Accounts

individual accounts. For those households for whom individual accounts

closely resemble 401(k)s and IRAs, a shift to individual accounts might

lead them to decrease their use of these accounts.17 They would have

additional retirement income possibilities available and might choose to

reduce their retirement or other saving to use for consumption in the

present rather than in the future. However, unless they were target savers,

i.e., savers who were trying to reach a specific retirement income goal,

they might not reduce their other savings dollar for dollar with individual

accounts.18 Therefore, we might expect some reduced saving by a

significant number of households; for certain households, we might expect

a substantial reduction.

Under a voluntary approach, the households that are most likely to

participate are those households that are currently saving but that face

some constraint in terms of the type of retirement saving they can do or

the amount of tax-preferred saving they are allowed. For example,

someone whose employer offered only a defined benefit retirement plan or

a defined contribution plan with very limited options might find that

voluntary individual accounts offered a new opportunity. In addition,

someone who was already contributing as much as he or she was legally

allowed to tax-deferred savings would find a voluntary program attractive

if it allowed an additional amount of tax-deferred saving. These and others

who take advantage of a voluntary program may be more likely to reduce

other forms of saving in response.

Households that are currently not saving, either because they are resource

constrained or because they are not forward-looking, would be forced to

save some amount by a mandatory individual account system. Households

in such situations may welcome the additional resources, especially if they

do not come from a direct reduction in their own consumption. However,

such households may also try to transform some of the additional

resources into consumption if they are able to borrow from the accounts

or otherwise tap into the accounts before retirement. To maintain

retirement income adequacy and to keep savings from being dissipated, it

 

17 See National Academy of Social Insurance, Report of the Panel on Privatization of Social Security,

1998 pp. 2-4.

18 See Eric M. Engen and William G. Gale, “Effects of Social Security Reform on Private and National

Savings” Social Security Reform, Links to Saving, Investment, and Growth, Conference Series No. 41,

June 1997, pp. 103-142.
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 33 GAO/GGD-99-115 Issues Associated With Individual Accounts

may be necessary to prohibit or restrict borrowing or other methods of

drawing down individual accounts prior to retirement. 19

Even with such restrictions, it may not be possible to completely eliminate

all options that households could use to indirectly increase consumption

from individual accounts. For example, households with little or no

retirement saving or other financial wealth could have wealth in some

other form, such as home equity. It is conceivable that such households

could borrow against that home equity as a way of turning their increased

future consumption into present consumption.

In addition to the effects of individual accounts on household savings there

are also other potential indirect effects on private saving. For example, the

incentives for employers to provide retirement benefits, either through

defined benefit or defined contribution plans, could be affected by

individual accounts. In addition, if less compensated workers in a defined

contribution plan reduce their contributions to the plan, higher

compensated workers may be required to reduce their own contributions

under the antidiscrimination rules.

Offsetting these tendencies to reduce saving, however, there are some

economists who believe that individual accounts might encourage certain

individuals to save more for retirement and thus not reduce their current

savings.20 Such an effect is more likely to be present if there is some form

of matching by the government as part of the individual account proposal.

Others believe that to the extent that a lack of saving is based on people

not taking a long enough view, the presence of individual accounts and

watching them accumulate could give people a better sense of how saving

small amounts can add up over time. This, plus observing how

compounding21 works, could induce some to save who otherwise would

not.

National saving is more likely to be increased by some approaches to

individual accounts than by others. Using sources of government funding

that would more likely have resulted in spending rather than saving

 

19 While borrowing could potentially allow individuals to reduce retirement income, the option to

borrow can also be an attractive feature under a voluntary program. For discussion of the trade-off see

401(k) Pension Plans: Loan Provisions Enhance Participation But May Affect Income Security

(GAO/HEHS-98-5, October 1, 1998).

20 Based on James M. Poterba, Steven F. Venti, and David A. Wise, “How Retirement Saving Programs

Increase Savings,” Journal of Economic Perspectives, Volume 10, Number 4, Fall 1996, pp. 91-112.

21 Interest accrued on a daily, quarterly, semiannual, or annual basis.
Chapter 2

Capital and Annuities Markets Able to Absorb Individual Account Investments

Page 34 GAO/GGD-99-115 Issues Associated With Individual Accounts

decreases the likelihood that government saving would be reduced.

Proposals that are mandatory are more likely to increase private saving

because a mandatory program would require that all individuals, including

those who do not currently save, place some amount in an individual

account. Certain prohibitions or restrictions on borrowing or other forms

of preretirement distributions would also limit the ability of some

households to reduce their savings in response to individual accounts.

SSA commented that we needed to discuss the savings implications of the

President’s proposal. This report was not intended to comment on specific

reform proposals.

Agency Comments
Chapter 3

Return and Risks Are Likely to be Higher With

Individual Accounts

Page 35 GAO/GGD-99-115 Issues Associated With Individual Accounts

There is a risk/return trade-off for individuals under an individual account

program; instituting such a program would likely raise both the risks and

the returns available to participants compared to the current system. In

order to receive higher returns, individuals would have to invest in higher

risk investments. The return that individuals receive would depend on

both their investment choices and the performance of the market.

Individuals who earn the same wages and salaries and make the same

contributions to Social Security could have different retirement incomes

because of the composition of their portfolios and market fluctuations. As

with any investment program, diversification and asset allocation could

reduce the risks while still allowing an individual to earn potentially higher

returns.

Most advocates of individual accounts state that the expected return on

investments under an individual account program would be much higher

for individuals than the return under the current Social Security program.

Proponents of individual accounts usually point out that equities have

historically substantially yielded higher returns than U.S. Treasuries, and

they expect this trend to continue. Others are skeptical about the claims

for a continuation of such a high expected return on equities. They state

that history may not be a good predictor of the future and that the

expected premium generated by investing in equities has steadily been

declining. Furthermore, they state that even if expected equity returns are

higher than other investments, equity returns are risky. Thus, in order to

determine what returns individuals might expect to receive on their

individual account investments, the riskiness of the investment should be

taken into account. Adjusting returns to include risks is important, but

there are many ways to do this, and no clearly best way.

Lastly, comparing the implicit rate of return that individuals receive on

their Social Security contributions to expected rates of return on market

investments may not be an appropriate comparison for measuring whether

individuals will fare better under an individual account system. Such

comparisons do not include all the costs implied by a program of

individual accounts. In particular, the returns individuals would effectively

enjoy under individual accounts would depend on how the costs of the

current system are paid off. Rates of return would also depend on how

administrative and annuity costs affect actual retirement incomes.1

 

1

 In a forthcoming report, we will provide a more detailed discussion on issues comparing Social

Security rates of return with those of market investments.
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 36 GAO/GGD-99-115 Issues Associated With Individual Accounts

An individual account program would offer individuals the opportunity to

earn market returns that are higher than the implicit returns to payroll

under the current Social Security program. However, investing in private

sector assets through individual accounts involves a clear trade-off--

greater return but more risk or more variability in future rates of return.

Under the current Social Security program, risks are borne collectively by

the government. Moving to an individual account program would mean

that individuals reap the rewards of their own investments, but they also

incur risk—not only about future returns, but also the possibility of losing

money and even having inadequate income for retirement. However,

holding assets for the long term, diversification, and the proper asset

allocation can mitigate certain risks and improve an individual’s risk/return

trade-off.

A trade-off exists between risk and return in investments. If an individual

is willing to consider the possibility of taking on some risk, there is the

potential reward of higher expected returns. The capital markets offer a

wide variety of investment opportunities with widely varying rates of

return, which reflect variations in the riskiness of those investments. For

instance, Treasury Bills are considered to be relatively risk free because

they have almost no default risk and very little price risk.2

 Alternatively,

equities are considered to be relatively risky because the rate of return is

uncertain.

Because debt holders are paid out of company income before

stockholders, equity returns are more variable than bonds. Overall, annual

returns on equities are more volatile than returns on corporate bonds or

Treasuries. On a long-term average basis, the market compensates for this

greater risk by offering higher average returns on equities than on less

risky investments. Thus, among the three types of investments, corporate

equities are the riskiest investments but pay the highest returns, followed

by corporate debt and then Treasuries. However, holding riskier

investments such as equities over long periods of time can substantially

diminish the risk of such investments.

The degree of risk and the size of potentially higher returns with individual

accounts depend on the equities chosen as well as the performance of the

market. A stock’s value is tied to the expected performance of the issuing

company. If the company does well, investing in individual equities could

be very lucrative for investors. However, if the company does poorly,

 

2

 Treasury securities are subject to interest rate risk. Treasury bonds and notes are subject to more

interest rate risk than Treasury bills, which are basically considered to be risk-free assets.

Instituting an

Individual Account

Program Means

Greater Risk to

Individuals for

Potentially Greater

Return

Risk/Return Trade-Off
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 37 GAO/GGD-99-115 Issues Associated With Individual Accounts

investing in individual equities could result in low returns or losses to the

investor. Many financial analysts go through intensive research to try and

pick the best stocks. Choosing the right stock, however, can be mostly a

matter of a “random walk.”3

Individuals may mitigate the risk of holding equities and bonds by

diversifying their portfolios and allocating their investments to adjust their

risk exposure and to reflect their own risk tolerance and circumstances.

Ultimately, the composition of an individual portfolio, along with the

performance of the market, determines the return individuals receive and

the risk they bear.

In constructing a portfolio investors combine equities and bonds and other

“securities” in such a way as to meet their preferences and needs,

especially their tolerance for risk. Individuals manage their portfolios by

monitoring the performance of the portfolios and evaluating them

compared to their preferences and needs. Many people have been

managing portfolios for years. There are, however, many others who

either do not have portfolios or do not consider what they have as a

portfolio. With individual accounts, all individuals would eventually have

to manage their portfolios as they start to own various investments,

especially if they have options over individual securities or types of

securities.

A well-diversified portfolio could help to diminish risk without lowering

the return, thereby improving the risk/return trade-off. For instance, a

properly selected combination of risky assets can have a lower risk than

any of its individual assets because the risk is spread out among different

assets allowing for gains in some assets to offset losses in others. Such

portfolios could provide higher average returns over the long term than a

single asset with equal risk. Furthermore, diversifying an equity portfolio

across companies and industries reduces both default and concentration

risk4

 and reduces the likelihood that a portfolio’s return will vary widely

from the expected market return.

In order to quantify the diversification of a portfolio, concepts like

correlation and covariance are used to measure how much the returns on

 

3

 That is, choosing the right stock is a random and unpredictable process.

4

 Depending on the composition of an individual’s stock portfolio, an individual could be exposed to

“concentration risk,” or the potential loss resulting from a heavy investment in a group of related

companies or an industry susceptible to the same economic dynamics. Individuals could also face

“default risk,” or the exposure to loss due to an individual company failing.

Diversification Improves

Risk/Return Trade-Off
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 38 GAO/GGD-99-115 Issues Associated With Individual Accounts

assets move in tandem with one another. For instance, if annual returns

on different investments are not very correlated, their risks can offset each

other even though they still individually earn higher average returns. Such

techniques, however, are very sophisticated, require substantial data

analysis, and would require the help of professional advisors for the

average investor. However, there are ways for individuals to take

advantage of many of the benefits of diversification without needing to

calculate correlation and covariance measures. Indexing is one way to

broadly diversify an equity portfolio and to match the approximate market

return.5

 Typically, investing in broad-based stock indexes such as the

Standard & Poor’s 500 index—which represents about two-thirds of the

value of the U.S. stock market—diversifies an individual’s portfolio by

reducing the likelihood of concentrating investments in specific

companies. Such investments also tend to reduce turnover and lower

administrative costs because they do not involve as much research or

expensive investment advice.

A diversified stock portfolio, however, does not protect against the risk of

a general stock market downturn. One way to mitigate U.S. stock market

risk is to diversify into international markets. An investor can also shield

against general stock market risk by diversifying into other types of assets,

such as corporate bonds. To minimize exposure to short-term stock

market fluctuations, an investor can hold less risky, albeit lower yielding,

assets to cover liquidity needs in the short run.

Asset allocation can provide an approach to portfolio diversification. For

example, percentages can be allocated to equities (including indexes),

bonds, and Treasuries. These allocations will generally reflect preferences

for risk as well as an individual’s life-cycle phase. Those with a higher

tolerance for risk and those who are younger would generally invest more

in equities. Those in later life-cycle phases might invest more in bonds or

Treasuries.

The primary risk that individuals would face with diversified or indexed

individual account investments is “market risk,” the possibility of financial

loss caused by adverse market movements. When the stock market drops,

prices of some equities fall and can stay depressed for a prolonged period

of time. Although a long investment time horizon provides the individual

 

5

 Indexing reduces risk or exposure to loss associated with an individual company failing and industryspecific downturns. The securities held in a broadly based indexed portfolio would represent many

different sectors of the economy and many individual companies. This diversification reduces the risk

that any loss related to the performance of an individual security or group of securities would greatly

affect the overall performance of the portfolio.

Individuals Bear Most of the

Risk
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 39 GAO/GGD-99-115 Issues Associated With Individual Accounts

more time to recover from short-term fluctuations, an individual also

would have more time to encounter a prolonged stock market downturn.

Thus, although long periods of time can help mitigate the effects of market

risk, it does not disappear over time.

Under most individual account programs, individuals would bear much if

not all of the market risk.6

 Although market risk would not increase with

the introduction of an individual account program, more people would be

exposed to it under an individual account program than are under the

current Social Security system. Some individuals would do very well

under such an individual account program, but others may not do as well

and could experience a significant drop in their expected retirement

income compared to others in the same age group or to the current Social

Security program. Furthermore, those who are reluctant to invest in the

stock market may not benefit from the potentially higher returns of equity

investing. Thus, the investment choices individuals make, as well as the

performance of the market, would determine the return they would receive

under an individual account program.

Individuals who retire at the same time may receive different pay-outs

from individual account investments because of the choices they have

made. Although some individuals could make the same choices,

individuals are more likely to make different choices. In part, differences

may come about due to luck; other differences may be more systematic.

For instance, higher income people may be willing to take on more risk—

and possibly earn higher returns—than lower income people. For this

reason, higher income individuals could earn higher rates of return than

lower income individuals under an individual account program, which is

not the case under the current Social Security program.

Many programs also provide for a default option for those who do not wish

to take an active part in investing in individual accounts. One type of

default option would provide investments in Treasuries with very low risk

and a low return. Others could provide an asset allocation, possibly age

related, with more equities included for younger workers and more

Treasuries for older workers.

Returns could vary across cohorts7

 as well under an individual account

program. Even if some cohorts made the same choices, given the volatility

 6

 There are some proposals that protect the individual against some or all of the downside risk.

7

 Cohorts pertain to a large group of people with similar characteristics. For example, people of the

same age would be in the same age cohort.

Individual Returns May Vary

Under an Individual Account

Program
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 40 GAO/GGD-99-115 Issues Associated With Individual Accounts

of the stock market, the returns could vary substantially across different

time periods and affect cohorts differently. For instance, even if the

market experienced no dramatic or long-lasting downturns, the market

will create “winners” and “losers” depending on when and how individuals

invest their individual account investments and when they liquidate their

holdings.

As long as workers are aware of and accept the idea that returns may vary

across individuals as well as cohorts, there will probably not be calls to fix

the “unfair benefits outcomes.” However, if large differences in outcomes

become commonplace, many participants could become dissatisfied with

the program and demand some payment from the government to make up

for any losses they incur or even if substantial differences result. For

instance, those that have incurred losses may expect the government to

mitigate their losses when they do not receive the return they believe they

were led to expect.

Furthermore, individual accounts are at least in part an attempt to finance

the unfunded liability with the excess returns of equities over

nonmarketable Treasuries. To the extent that individuals receive low or

even negative returns over time, individual account investments could

actually lead to an increase in the unfunded liability of the current Social

Security program.

The expected return from investments of individual accounts is likely to be

higher than the average implicit rate of return of the current system, but it

is unlikely to be as high as many advocates presume. Advocates and

opponents of individual accounts have estimated what the likely market

return would be for an individual’s investments under an individual

account program. When discussing equity returns, advocates often point

to the fact that equities have historically yielded higher returns than

Treasuries. They expect returns on equities to continue to be higher than

Treasuries and to boost individual returns on individual account

investments.

Other economists are skeptical that the higher returns presumed under an

individual account program will be realized. They state that history may

not be a good predictor of the future. Others state that even if expected

equity returns are higher than other investments, equity returns are risky.

For instance, the average historical return reveals nothing about how

variable that return has been from year to year. Thus, in an estimation of

an expected return to investments of individual accounts, the riskiness of

the investment should be taken into account. Estimating expected returns

The Expected Market

Return for Individual

Account Investments
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 41 GAO/GGD-99-115 Issues Associated With Individual Accounts

without mention of the risk and costs of the investments will overstate the

benefits of investing in marketable securities because the return on

marketable securities varies substantially with the riskiness of those

investments.8

Advocates of individual accounts have stated that individuals would

receive higher returns by investing in the stock market than they receive

under the current Social Security program. Although,comparing

investment returns with the rate of return paid by Social Security is always

problematic, advocates of individual accounts point out that the rate of

return on equities has been significantly higher than other rates of returns.

For instance, compounded annual average rates of return on equities have

averaged about 7 percent per year since 1900 and 6 percent per year since

1957. Alternatively, the compounded annual average return on Treasuries

has been between 1 and 2 percent per year on an inflation-adjusted basis,

and long-term corporate bonds have averaged 2 percent.

The capital markets generally offer higher potential rates of return on

riskier investments such as equities. Figure 3.1 shows the annual returns

of Standard & Poor’s (S&P) 500 Index, which is a measure of the

performance of the stocks of 500 large companies traded on the U.S. stock

exchange. Actual nominal (non-inflation-adjusted) returns for large

company stocks varied widely from the annualized average return over

long periods and have ranged from a low of minus 26.5 percent in 1974 to

a high of 52.6 percent in 1954.

 8

 For detailed information on how administrative costs can have a direct effect on how much savings

are accumulated in individual accounts over time see Social Security Reform: Administrative Costs for

Individual Accounts Are Hard to Predict (GAO/HEHS-99-131, June 18, 1999).

Future Returns to Equities

Uncertain
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

Page 42 GAO/GGD-99-115 Issues Associated With Individual Accounts

Source: Haver Analytics.

As can be seen in figure 3.1, returns are variable. An average return over a

long period of time can obscure the reality that equity returns fluctuate

substantially from year to year. There have also been years in which

equities have yielded negative returns. For instance, over the past 70 years

or so, equity returns were negative in nearly 1 out of every 4 years.

Even taking into account the variability of returns, some analysts have

suggested that historic U.S. returns may overstate future returns. They

state that the equity markets in the United States have tended to

outperform the equity markets in other countries. Thus, when relying on

historical data as the basis for estimates of long-term market growth, if one

looks not just at U.S. data, but also at the historical returns of other

countries, then the high historical returns to equities in the United States

could be an exception rather than the rule.9

 Historical returns are the only

empirical basis with which to judge equity returns, but there is no

guarantee that the future will mirror the averages of the past in the United

States as opposed to some subperiod of the U.S. market or, alternatively,

returns to foreign stock markets.10

 

9

 See Philippe Jorion and William N. Goetzmann, A Century of Global Stock Markets, National Bureau

of Economic Research Working Paper 5901, July 1997.

10 See John E. Golob and David G. Bishop, “What Long-Run Returns Can Investors Expect from the

Stock Market?” Federal Reserve Bank of Kansas City Economic Review, vol. 82, No. 3 (Third Quarter

1997), pp. 5-20;and John H. Cochrane, “Where is the Market Going? Uncertain Facts and Novel

Theories,” Economic Perspectives, Vol. XXI, Issue 6 (November/December 1997), pp.3-37.

Figure 3.1: Returns of the Standard and

Poors 500 Index
Chapter 3

Return and Risks Are Likely to Be Higher With Individual Accounts

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In general, investors, tend to be averse to risk and demand a reward for

engaging in risky investments. The reward is usually in the form of a risk

premium—an expected rate of return higher than that available on

alternative risk-free investments. For instance, the historical advantage

enjoyed by equity returns over the returns of other assets is what is known

as the equity premium. The premium is said to exist because equities have

historically earned higher rates of return than those of Treasuries to

compensate for the additional risk associated with investing in equities.

However, the equity premium has slowly been declining. Studies have

shown that the equity premium has declined since the 1950s.

A number of studies have attempted to measure the equity premium as

well as explain its size. One study11 found that the premium appeared to be

quite high in the 1930s and 1940s and was caused by the perception of the

high volatility in the stock market in the late 1920s and the early 1930s.

This led investors to favor less risky securities as opposed to equities,

generating a high equity premium. However, as the volatility of stock

market declined after the 1929 stock market crash, the appeal of investing

in equities began to increase; and although an equity premium continues to

exist, it has steadily declined. However, in the 1970s the equity premium

increased somewhat from its general downward trend; this was attributed

to inflation.12 The study concluded that decreases in the equity premium

were the result of increases in expected bond rates and decreases in the

expected rates of returns to equities.

It has also been suggested that the shrinking premium reflects a structural

change in that the economy appears less susceptible to recessions.13 To

the extent that corporate profits fluctuate with general economic

conditions, fewer downturns translate into less volatility in corporate

earnings. If investors perceive that the outlook for corporate earnings is

more certain and that equities may be less risky than they have been

 

11 See Oliver J. Blanchard, “Movements in the Equity Premium,” Brookings Papers On Economic

Activity, 2:1993, pp. 75-118.

12 The study noted that inflation causes higher dividend yields, which in turn increases the return to

stocks. Alternatively, inflation leads to a decrease in real bond rates, for a few years only. This means

that the relationship between inflation and the equity premium is strong in the short run because

inflation affects real bond rates, but it is not so strong in the long run because the effect of inflation on

bond rates is not as lasting.

13 Goldman Sachs, “The Equity Risk Premium and the Brave New Business Cycle,” U.S. Economics

Analyst, No. 97/8, February 21, 1997.

Equity Premium Diminishing
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historically, equity investing might carry a lower premium and, therefore,

relatively lower returns. As a result, the equity premium diminishes.

It is unclear whether the equity premium will continue to decline.

However, if individual accounts affect equity prices in the short run, the

equity premium could decrease. For instance, if the demand for equities

increases as a result of individual accounts, the prices of equities are likely

to increase. This in turn lowers the expected return on equities. As the

expected return on equities decreases, the equity premium decreases

because the difference between the return on equities and the risk-free

asset such as Treasury bills would diminish.

The decreasing equity premium could imply that people do not view the

stock market to be as risky as they once did. One possible implication is

that if people view the stock market as not very risky, and they prove to be

right, they will continue to invest in it, and the equity premium is likely to

continue decreasing. Alternatively, if the stock market is in fact riskier

than investors believe, then investors will be surprised by

underperformance and volatility over time and will begin to reduce their

equity holdings, which could eventually cause the equity premium to go

back to values consistent with past decades.

The size of the equity premium has implications for analyzing the benefits

of an individual account program.14 The potential gain from equity

investing under an individual account program depends on what future

equity returns are and in particular how much return might be expected

for taking on additional risk. A significant part of the gain that might be

generated from diversifying into equities comes from the equity premium.

To the extent that the equity premium continues to decline, individuals are

unlikely to receive as high a return from stock investing as they have in the

past.

The return that individuals are likely to receive from individual account

investments would depend on what they are allowed to invest in, e.g.

stocks, bonds, indexed mutual funds,15 as well as the risk of the asset being

invested in. When estimating expected returns under an individual

account program, most proposals have tended to focus on equities.

 

14 See Implications of Government Stock Investing for the Trust Fund, the Federal Budget, and the

Economy (GAO/AIMD/HEHS-98-74, April 22, 1998).

15 Mutual funds pool the limited funds of small investors into large amounts, thereby gaining the

advantages of large-scale trading. Investors are assigned a prorated share of the total funds according

to the size of their investments.

The Returns of Investments
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However, other assets may offer different returns. Corporate equities have

tended to have higher market returns than other investments because they

are riskier. Other investments, such as corporate bonds, have also tended

to offer high yields. For instance, corporate bonds offer higher yields than

Treasuries to entice investors to buy these securities, which have some

risk of default.16 As in the case of corporate equities, investors are offered

a higher reward for taking on the additional risk that the company may

default. If an individual account system were to provide for mutual funds,

depending on the type of mutual fund allowed, individuals would receive

various returns. For instance, a government bond mutual fund may yield a

lower return to investors than an equity indexed mutual fund.17

Overall, the capital markets offer higher market returns only by having

investors take on additional risk. Thus, in estimating expected returns for

individual account investments, it is important to not only consider the

type of asset invested in but also the riskiness of the investment.

Higher returns are possible for individuals investing through individual

accounts than under the current Social Security program, but only if

individuals take on more risk. Individuals should therefore not only be

interested in the returns of various assets but also in the risks that have to

be incurred to achieve higher returns under an individual account

program. The difficulty is how to measure risk and how to adjust rates of

return for risk so that investors would be able to compare various returns

to investments.

Risk is often considered to be the uncertainty of future rates of return,

which in turn are equated with variability. In fact, one of the underlying

concepts of risk is inherent volatility or variability. For instance, the

variability of equity prices is among the key factors that cause investors to

consider the stock market risky. The price at which an individual

purchases shares of a company early in the morning is not guaranteed

even later in the day. Bond prices also vary due to changing interest rates

and inflation.

 

16 When a bond is purchased, the coupon rate is fixed and known for the life of the bond—this is the

rate the purchaser will receive every 6 months for the life of the bond.

17 An indexed mutual fund is a mutual fund that holds shares in proportion to their representation in a

market index such as the S&P 500.

Adjusting the Rate of

Return for Risk
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There are a number of different ways to try to measure variability or risk.

All such measures give some estimate of the riskiness of investments.

Classic risk measures such as variance18 or the standard deviation19

 are

often used to measure the risk of an asset. However these measures are

often considered to be difficult for investors to understand and may not

reflect how people perceive risk. For instance, investors do not generally

take a symmetrical view of the variability of returns—downward

deviations are perceived as economic risks, but upward deviations are

regarded positively or as unexpected gains. Furthermore, quantifying

uncertainty or risk is usually done using probability distributions. As long

as the probability distribution falls symmetrically about the mean or

average—what is known as a normal distribution—the variance and

standard deviation are adequate measures of risk. However, to the extent

that the probability distributions are asymmetrical, as is the case with the

returns from a combination of securities, those measures are not as

meaningful in terms of measuring risk.

Other ways to measure risk include (1) the value at risk (VAR) --how much

the value of a portfolio can decline with a given probability in a given time

period, or (2) the beta of a security--the tendency of a security’s returns to

respond to swings in the broad market. VAR is an approach used by

money risk managers to measure the riskiness of their portfolios. It is an

estimate of the maximum amount a firm could lose on a particular

portfolio a certain percent of the time over a particular period of time. For

example, if an investor wanted to put money into a mutual fund and

wanted to know the value at risk for the investment of a given time period,

the investor could determine the percentage or dollar amount that their

investment could lose, e.g., a 2-percent probability that the investor could

lose at least $50 of a $1,000 investment over a certain period of time. VAR

models construct measures of risk using the volatility of risk factors, such

as interest rates or stock indexes, which is helpful for mutual funds that

have a wide variety of investments.

Measuring the beta is another way to measure risk. In essence, if an

investor wanted to know how sensitive a particular asset’s return is to

market movements, calculating the beta would do so. Beta measures the

amount that investors expect the equity price to change for each additional

1-percent change in the market. The lower the beta, the less susceptible

the stock’s return is to market movements. The higher the beta, the more

 18 The variance of an asset’s return is the expected value of the squared deviations from the expected

return. The variance tries to measure the dispersion of the returns.

19 The standard deviation is the square root of the variance.

There are Many Ways to

Measure Risk
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susceptible the stock’s return is to market movements. Thus, the beta

would measure the risk that a particular stock contributes to an

individual’s portfolio.

As previously stated, estimating a return on investments without taking in

to account the riskiness of the investment is likely to overstate the benefit

of investing in that asset. Adjusting returns to account for risk is

important because risk-adjusted returns are likely to be lower than

unadjusted returns but more comparable across asset classes.

There are different ways to adjust returns for risk, but there is no clear

best way to do so. The appropriate risk-adjusted measurements depend on

what is being evaluated. For instance, in terms of evaluating the returns of

mutual funds, various risk-adjusted performance measures could be used.20

One measure used is the Sharpe Ratio,21 which basically measures the

reward to volatility ratio and is the most commonly used measure for

determining the risk-adjusted performance of mutual funds. A high Sharpe

ratio means that a mutual fund delivers a high return for the level of

volatility of the fund’s investments. Thus, if individuals were trying to

determine the mutual fund that had the best combination of return for risk,

they would choose the fund that had the highest Sharpe Ratio. An

alternative to the Sharpe Ratio is the Modigliani Measure, which measures

a fund’s performance relative to the market. The measure uses a broadbased market index, such as the S&P 500, as a benchmark for risk

comparison. In essence, the measure is equivalent to the return a mutual

fund would achieve if it had the same risk as a market index. Another

measure is one calculated by Morningstar, Incorporated. Unlike the

Sharpe Ratio, which compares the risk-adjusted performance of any two

mutual funds, Morningstar measures the risk-adjusted performance of

mutual funds within the same asset class. It usually assigns ratings to

mutual funds on the basis of the risk-adjusted return and risk of a mutual

fund.22 Thus, if individuals wanted to know how various mutual funds did

within their asset groups, they would look at the Morningstar rating.

 

20 See Katrina Simons, “Risk-Adjusted Performance of Mutual Funds,” New England Economic Review,

September/October 1998., pp.34-48.

21 The Sharpe Ratio measures a mutual fund’s excess return per unit of risk (fund’s average excess

return divided by the standard deviation of the fund’s excess return).

22 Morningstar calculates its risk-adjusted return measure by calculating an excess return measure for

each fund by adjusting for sales loads and subtracting the 90-day Treasury bill rate and then dividing

the excess return by the average excess return for the fund’s asset class. Morningstar calculates a

measure of downside risk by counting the number of months in which the fund’s excess return was

negative, summing up all the negative excess returns, and dividing the sum by the total number of

months in the measurement period.

Adjusting for Risk
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There are other risk-adjusted measures that are used. However, there is

no clear best way to adjust a return for risk, and there is no one riskadjusted measure that everyone agrees is the correct measure. Many of

the measures are complicated and may require more sophistication to

understand than could be expected of individual account investors. It

should be noted, however, that although risk-adjusted rates of return are

the appropriate measure for individual account investments, an investor’s

entire portfolio has a different risk than that of its individual components.

Thus, risk-adjusted returns depend fundamentally on how portfolios are

managed.

Comparing rates of return on Social Security and private market

investments has frequently been discussed in evaluating options for

reforming Social Security, but comparing the two does not capture all the

relevant costs and benefits that reform proposals imply.23 Such

comparisons often do not factor in the costs of disability and survivors

insurance when determining a rate of return on Social Security

contributions for retirement.

Individual accounts would generally increase the degree to which

retirement benefits are funded in advance. Today’s pay-as-you-go Social

Security program largely funds current benefits from current

contributions, but those contributions also entitle workers to future

benefits. The amount necessary to pay the benefits already accrued by

current workers and current beneficiaries is roughly $9 trillion. Any

changes that would create individual accounts would require revenues

both to deposit in the new accounts for future benefits and to pay for

existing benefit promises. Rate of return estimates for such a program

should reflect all the contributions and benefits implied by the whole

reform package, including the costs of making the transition.

Administrative and annuity costs could also affect actual retirement

incomes.

SSA commented that we needed to clarify that comparisons between the

rate of return implicit in the Social Security system and those of individual

accounts were problematic for many reasons including the fact that Social

Security provides survivors and disability insurance. We have further

clarified issues regarding the rate of return comparisons and have referred

to our forthcoming report that provides a more detailed discussion on

 

23 In a forthcoming report, we will provide a more detailed discussion on issues comparing Social

Security rates of return with those of market investments.

Comparing Rate of

Return From Social

Security to Expected

Return With Individual

Accounts Requires

Careful Consideration

Agency Comments
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comparing the rate of return implicit in the Social Security system with

those of market investments.
Chapter 4

Enhanced Education is Necessary for an

Individual Account Program

Page 50 GAO/GGD-99-115 Issues Associated With Individual Accounts

Under many of the individual account programs that have been proposed,

individual accounts to varying extents would be managed by participants

themselves. To operate fairly and efficiently, such a system would have to

provide participants with information adequate for their decisionmaking as

well as to protect against misinformation that could impair that process.

Existing SEC disclosure and antifraud rules and related doctrines provide

for the disclosure of information that is material1

 to an investment

decision. However, such disclosure alone would not enable participants in

an individual account program to understand how best to use such

information for purposes of their retirement investment decisions.

To provide participants with a clear understanding of the purpose and

structure of an individual account program, an enhanced educational

program would be necessary.2 Such an enhanced and broad-based

educational effort would have to be undertaken in order to provide

individuals with information they need and can readily understand, as well

as with tools that can help both improve the decisionmaking process and

awareness of the consequences of those decisions. Individuals would need

education on the benefits of saving in general, the relative risk-return

characteristics of particular investments, and how different distribution

options can affect their retirement income stream. If a wide variety of

choice is offered individuals so that they could potentially choose less

diversified investments, such as individual equities, a more broad-based

educational program would be necessary. The wider the variety of

choices, and thus more potential risks, offered individuals under an

individual account program, especially a mandatory program, the more

broad-based the education will need to be. If fewer, well-diversified

choices are provided under an individual account program, the educational

effort could be targeted more to the purpose for investing and the potential

long-term consequences. It is also likely that some sort of provision, such

as a default option--either a default to the defined benefit part of Social

Security (staying in the current Social Security program) or to a mandatory

allocation--may be needed for those individuals who, regardless of the

education provided, will choose not to make investment choices.

 

1

 Under the Securities laws, the term “material information” generally is understood to mean the

information that a reasonable investor would consider significant in making an investment decision,

taking into account the circumstances of the particular transaction and the total mix of publicly

available information.

2

 Such a program would have to acknowledge that not all participants will speak and read English and,

thus, educational materials may need to be in a variety of languages.
Chapter 4

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Existing disclosure rules require that material information be provided

about a particular instrument and its issuer. Such disclosure would be

essential to an individual account program, with some rules having more

significance than others, depending on the investment choices offered.

For example, if participants were allowed to acquire corporate securities

such as stocks and bonds, the disclosure and reporting requirements of the

Securities Acts of 1933 and 1934, such as those applicable to the

governance, activities, and financial status of the issuer, would be

particularly important to participants choosing such instruments. If

investment choices were limited to mutual funds, disclosure about the

funds would have primary importance, and information about the issuers

of the securities owned by the funds would be relatively less significant for

participants. In addition, the Employee Retirement Income Security Act of

1974 (ERISA) requires disclosures in connection with pension funds

(covered by Title I of ERISA). If products offered by banks and insurance

companies were permitted, special disclosure rules would apply.

The Securities Acts of 1933 and 1934 generally require disclosure and

reporting of detailed information about an issuer of securities, such as its

management, activities, and financial status. The Securities Act of 1933

(1933 Act) primarily focuses upon the disclosure of information in

connection with a distribution of securities; the Securities and Exchange

Act of 1934 (1934 Act) concentrates upon the disclosure of information

trading, transactions, and sales involving securities.

The 1933 Act requires the disclosure of information intended to afford

potential investors an adequate basis upon which to decide whether or not

to purchase a new security and to prevent fraudulent conduct in

connection with the offering. This disclosure generally takes place

through a registration statement filed with SEC (and made available to the

public, except for confidential information) and a related prospectus.

Both documents contain detailed factual information about the issuer and

the offering, including statements about the specifics of the offering as

well as detailed information about the management, activities, and

financial status of the issuer.

The 1934 Act, among other things, contains extensive reporting and

disclosure requirements for issuers of securities registered under the act.

Issuers must file current, annual, and quarterly reports with SEC, and the

annual report must be distributed to security holders. The 1934 Act also

governs brokers, dealers, and others involved in selling or purchasing

securities. The act contains a broad prohibition against fraud in

connection with securities transactions that frequently has served as a

The Significance of

Disclosure Rules

Would Depend Upon

Available Investment

Choices

Disclosures in Connection

with Securities and Pension

Plans
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basis for disclosing to customers an abundance of details about a

particular instrument or transaction.

ERISA and DOL regulations require the administrator of a plan covered by

Title I of ERISA to file certain information about the plan with DOL and

distribute it to plan participants and beneficiaries receiving benefits.3 One

of the principal disclosure documents, the summary plan description

(SPD), must include information specified in the regulations, which

includes details about the structure, administration, and operation of the

plan as well as the participant’s or beneficiary’s benefits and rights under

the plan. The SPD must be written in a manner “calculated to be

understood by the average plan participant” and must be “sufficiently

comprehensive to apprise the plan’s participants and beneficiaries of their

rights and obligations under the plan.” Moreover, in fulfilling these

requirements the plan administrator is to take into account “such factors

as the level of comprehension and education of typical participants in the

plan and the complexity of the plan.”4

In addition to general reporting and disclosure requirements, DOL

regulations contain special disclosure rules for participant-directed

accounts. A participant-directed account plan is one that permits

participants and beneficiaries to direct the investment of assets in their

individual accounts. 5 The special rules arise in the connection with the

obligations of a fiduciary to a plan that permits such accounts.

 

3

 ERISA’s regulatory provisions are contained in four parts. Part I covers reporting and disclosure

requirements, which are designed to improve pensions and protect employees by mandating disclosure

of certain plan information to the government, participants, and beneficiaries. Part II establishes

minimum vesting requirements and minimum participation standards, which are intended to lessen

discrimination against lower level employees and broaden the coverage of pension plans. Part III sets

minimum funding standards to improve the stability of certain defined-benefit pension plans. Part IV

defines standards of conduct for pension plan fiduciaries and prohibits certain transactions.

4

 In addition to the SPD, a plan administrator is required to provide each participant with a summary

annual report which, among other things, is to include detailed information regarding the amount of

administrative expenses incurred by the plan, the amount of benefits paid to participants and

beneficiaries, the value of plan assets, income or loss for the year, and the amount of net unrealized

appreciation in plan assets during the plan year.

5

 Regulations for participant-directed accounts specifically require that such accounts provide the

participant or beneficiary the opportunity to choose from a broad range of investment alternatives.

These alternatives must provide a reasonable opportunity for a participant or beneficiary to: (1)

materially affect the potential return on amounts in his or her individual account with respect to which

he or she is permitted to exercise control and the degree of risk to which such amounts are subject; (2)

choose from at least three investment alternatives; and (3) diversify the investment of that portion of

his or her individual account with respect to which he or she is permitted to exercise control so as to

minimize the risk of large losses.
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Under DOL regulations, a fiduciary can avoid liability for any loss arising

from the participant’s exercise of control over account assets, provided

that the participant has the opportunity to exercise control over the

account assets and may choose, from a broad range of investment

alternatives, the manner in which assets are invested. The regulations

further provide that a participant has the opportunity to exercise control

only if, among other things, the participant is provided or can obtain

information sufficient for him or her to make informed investment

decisions. This information includes (a) a description of investment

alternatives and associated descriptions of the investment objective, risk

and return characteristics of each such alternative; (b) information about

designated investment managers; (c) an explanation of when and how to

make investment instructions and any restrictions on when a participant

can change investments; and (d) a statement of fees that may be charged

to an account when a participant changes investment options or buys and

sells investments.

The information that the 1933 and 1934 Acts require issuers to disclose

pertains to details about the issuers of securities and the securities

themselves. Such information is significant to a person investing in a

specific issuer. For the purchaser of shares in an investment company,

such as a mutual fund, which is the vastly prevalent form of investment

company, information about the company itself, rather than individual

issuers, is most significant. Mutual funds are subject to the Investment

Company Act of 1940, which deals with the registration, formation, and

operation of investment companies, as well as provisions of the 1933 and

1934 Acts governing disclosure and prohibiting fraud. Disclosure about

the fund, such as information concerning its investment strategies and its

management, is provided in the registration statement filed with SEC; the

prospectus or an alternative, less detailed document known as a “profile”;

and periodic reports filed with the Commission and distributed to

shareholders.6

 

6

 As discussed later in the report, SEC recently modified Form N-1 and promulgated the “profile” rule

to provide for the disclosure of mutual fund information in a less detailed, more understandable

fashion. SEC instituted these changes because the proliferation of mutual funds and products

increased the volume and complexity of disclosures, thus leading to the confusion of mutual fund

customers.

Disclosure in Connection

With Mutual Fund Shares
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The expansion of products offered by depository institutions (primarily

federally insured banks and thrifts and their subsidiaries or affiliates) and

insurance companies carries with it the potential for confusion about the

nature and risk of investment products offered by such institutions. For

example, bank sales of nondeposit instruments, such as mutual fund

shares and variable annuities, could lead an investor to conclude that such

instruments are federally insured bank products. Investment products

sold by insurance companies, such as certain variable annuities and equityindexed agreements, might be viewed as traditional insurance products,

under which the insurer assumes the payment risk. If such products are

securities, they are subject to the requirements of federal and state

securities laws. The activities of institutions in connection with the

products would be subject to regulation under the securities laws as well

as regulation by their supervising agencies.

The federal bank regulators 7

 have promulgated rules, guidelines, and

policies containing standards for disclosure in connection with a banking

institutions’ involvement in sales of nondeposit instruments such as

securities. These regulators issued an Interagency Statement on Retail

Sales of Non-Deposit Investment Products (“Interagency Statement”)

together with subsequent statements that focuses on issues specifically

pertaining to the retail sale of investment products to customers on

depository institution premises. Among other things, the standards seek to

prevent customer confusion over whether such products are FDIC-insured,

primarily through disclosure and separation of sales of investment

products from other banking activities.

New products being offered by insurance companies can also confuse

investors about whether such a product is insurance (the insurer accepts

the repayment risk) or a security (the purchaser of the product faces some

or all repayment risk). States typically regulate disclosure about insurance

products by prohibiting unfair, deceptive, or misleading statements about a

product. However, to the extent such instruments are securities, their

purchase and sale are subject to federal and state securities laws.

To address concerns about the effectiveness of disclosures regarding

investing, particularly with respect to mutual funds, SEC and some states

have established programs to provide for disclosing information to

investors in a more understandable way. SEC’s “plain English” program is

 7

 The office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve

System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Thrift Supervision

(OTS).

Disclosure Concerning

Certain Products Offered by

Depository Institutions and

Insurance Companies

NonDeposit Bank Products

Initiatives to Facilitate

Understanding of

Information
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Page 55 GAO/GGD-99-115 Issues Associated With Individual Accounts

an example. The Commission instituted the program because much of the

disclosure provided in prospectuses and other documents often is

complex, legalistic, and too specialized for investors to understand. Under

this program, the Commission revised its rule for the presentation of

information in a prospectus to require that the prospectus comply with

plain English writing principles listed in the regulation. SEC also amended

its Form N-1A, the registration form used by mutual funds for registration,

to provide for the use of plain English principles and simplified

descriptions of information essential to an investor’s evaluation of the

fund.

In March 1998, SEC adopted a rule permitting mutual funds to offer

investors a new disclosure called a profile. The document summarizes key

information about the fund, including its investment strategies, risks,

performances, and fees, in a concise, standardized format. A fund offering

a profile can give investors a choice about the amount of information they

wish to consider before making a decision about investing in the fund.

Investors have the option of purchasing the fund’s shares on the basis of

the profile, in which case they are to receive the fund’s prospectus along

with the purchase confirmation.

Among other things, the new SEC rules are designed to reduce the

complexity of information provided to mutual fund customers and the

potential for confusion that sometimes accompanies such information.

They are an attempt to make the disclosure of material information more

useful to those who invest in mutual fund securities.

Whether an individual account program is mandatory or voluntary, giving

millions of working Americans the responsibility for investing part of their

Social Security payroll taxes on their own requires enhanced education.

Social Security has provided a safety net for millions of people for a long

time in that it has been the foundation of the nation’s retirement income

system, providing income for millions of Americans. Introducing an

individual account program would change the nature of the current Social

Security program and would require increased education if people are to

understand the individual account program and what may be required of

them. Although education would be necessary regardless of whether the

program was voluntary or mandatory, the government would have a

special responsibility under a mandatory program to provide individuals

with the basic investment knowledge that they would need in order to

make informed investment decisions affecting their retirement.

Enhanced Education Is

Necessary for an

Individual Account

Program
Chapter 4

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The extent to which enhanced education would be necessary would

depend upon the available investment choices and the fees and expenses

associated with an individual account program. An individual account

program that offers many investment choices—especially one that is

mandatory—would likely require a substantial amount of education

because the wider the options provided an individual, the greater the

chances are that the individual could lose money. If fewer well-diversified

options are offered under an individual account program the fewer risk

factors the individual has to consider and the more targeted the education

could be. It would also be important to educate individuals about how to

interpret the fees associated with individual account investments and how

fees would affect their account balances.

The Social Security program includes workers from all levels of income,

those who currently invest in equity and bond markets and those who do

not. It is unlikely that a “one size fits all” educational effort would be

appropriate for an individual account program. Because a mandatory

individual account program would require everyone to participate,

including those who do not currently make investment decisions,

educational efforts would be especially crucial and would need to reach all

individuals.

Large segments of the working population do not currently make

investment decisions for various reasons. For instance, some people do

not believe that they have enough money to save or at least to save in any

vehicle other than a bank account. Others do not know the benefits of

investing. Lastly, there are those who do not appear to understand the

benefits of saving and investing or the necessity of doing so for retirement.

Whatever the reason, millions of people have never made investment

decisions.

Investor education is especially important for individuals who are

unfamiliar with making investment choices, including low-income and less

well-educated individuals who may have limited investing experience.8

Thus, one of the primary areas of enhanced education under an individual

account program would be to educate those who do not know the basics

about savings or diversification, especially if the individual account

program is mandatory. Those individuals and households who do not

currently make investment decisions, but rely on Social Security as their

 8

 This is especially true for the 21 percent of the adult population with only rudimentary reading and

writing skills (at or below the fifth-grade level) according to the National Center on Education

Statistics).

Enhanced Education Is

Important for All

Individuals

Enhanced Education Is

Important for Those Who Do Not

Currently Make Investment

Decisions
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 57 GAO/GGD-99-115 Issues Associated With Individual Accounts

primary source of retirement income, are likely to be the ones who are

most affected by a mandatory individual account program and thus most in

need of education.

Congress and various agencies and organizations have instituted programs

to educate people about the benefits of saving and investing. In the

Savings Are Vital to Everyone’s Retirement Act of 1977, Congress

mandated an education and outreach program to promote retirement

income savings by the public. The act also required the Secretary of Labor,

in consultation with other federal agencies selected by the President, to

plan and conduct a National Summit on Retirement Savings. As part of

this mandate, the act required the Secretary to bring together retirement

and investment professionals, Members of Congress, state and local

officials, and others to discuss how to educate the public--employers and

individuals--about the importance of saving and about the tools available

to enable individuals to retire and remain financially independent.

Pursuant to this mandate, DOL sponsored the National Summit in 1998.

Other efforts have been made to reach out to investors to educate them

about both how to protect themselves against fraud. SEC has realized that

an important part of its role in combating fraud is to educate the public

about what to be aware of and how to avoid being taken advantage of. If

investors are adequately informed about the risks associated with potential

securities frauds, then they will be less likely to fall victim to scams.

SEC has implemented several programs to advise the investing public

about potential frauds. For instance, SEC has issued numerous pamphlets

about what types of questions investors should ask about investing and the

people who sell those products.9

 Additionally, SEC has held local “town

meetings” across the United States to discuss investment risks. It also

coordinates the “Facts on Savings and Investing Campaign” with federal,

state, and international securities regulators. SEC officials said that in

order to have a successful education program, it is necessary to determine

what people do and do not know. This has entailed determining people’s

level of literacy and math knowledge in order to design a program that

could provide education for individuals with various levels of investment

knowledge.

 9

 See pamphlets such as “Ask Questions,” “Cold Calling Alert,” “Invest Wisely: An Introduction to

Mutual Funds,” and “Invest Wisely: Advice from Your Securities Industry Regulator,” published by and

available from the U.S. Securities and Exchange Commission.

Current Initiatives Focus on

Saving, Fraud, and Retirement

Income
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 58 GAO/GGD-99-115 Issues Associated With Individual Accounts

DOL’s Pension Welfare and Benefits Administration has several

educational outreach efforts for encouraging employers to establish

retirement programs and employees to save for retirement. The basic

program is a joint effort with a wide range of private sector partners,

including the American Savings Education Council, the Employee Benefit

Research Institute, banks, insurance companies, consumer groups, retiree

groups, participant rights’ groups, mutual funds, and other large

companies. This joint effort was designed to provide very basic

information to individuals and employers about the different types of

savings vehicles available under the law and to encourage the private

sector to provide employees with models of pension programs.10 The

educational program tries to target special groups whose pension coverage

is low, including such groups as women and minorities as well as small

businesses; only about one-fifth of small businesses offer pension plans to

their employees. DOL has issued numerous pamphlets on what

individuals should know about their pension rights and what businesses

can do to start pension plans for their employees.11 For instance, they

regularly use the Small Business Administration’s newsletters to

encourage members to establish pension plans and have developed a Web

site for small businesses to give them information on various pension plan

options, depending on how much each business can afford to contribute to

a pension fund.

These current programs have a limited ability to reach the overall

population. One clear constraint is the low level of resources, including

funding directed to investor education. Another limitation is that they are

targeted to circumscribed audiences, such as companies that do not have

retirement programs as opposed to individuals who do not invest.

Furthermore, most efforts are reaching those individuals who choose to

take it upon themselves to find out what they need to do to save more or to

learn how to make better investment decisions. Thus, even as a result of

 

10 This joint effort resulted from a concern a few years ago that as baby boomers began to retire and

move away from defined benefit plans into 401(k) plans, there would be a great need for educational

efforts to encourage individuals to save for their retirement. At first, Congress did not support DOL’s

voluntary efforts. However, several years later as 401(k) plans became increasingly popular, Congress

passed the Savers Act, which requires DOL to establish and maintain a retirement education program

for employers and employees.

11 See pamphlets, “What You Should Know About Your Pension Rights,” “Simple Retirement Solutions

for Small Business,” “Simplified Employee Pensions: What Small Businesses Need to Know,” “Top 10

Ways to Beat the Clock and Prepare for Retirement,” “Reporting and Disclosure Guide for Employee

Plans,” “Protect Your Pension: A Quick Reference Guide,” “A Look at 401(k) Plan Fees’” and “Saving

Incentive Match Plan for Employees of Small Employers,” published by and available from the U.S.

Department of Labor, Pension Welfare and Benefits Association.
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 59 GAO/GGD-99-115 Issues Associated With Individual Accounts

the various targeted efforts undertaken, large segments of the population

are still not being reached.

Numerous studies12 have been done that have looked at how well

individuals who are currently investing understand investments and the

markets. On the basis of those studies, it is clear that among those who

save through their company’s retirement programs or on their own, there

are large percentages of the investing population who do not fully

understand what they are doing. For instance, one study found that a little

more than a third of American workers have tried to calculate how much

money they would need to retire comfortably. Another study found that 47

percent of 401 (k) plan participants believe that stocks are components of

a money market fund, and 55 percent of those surveyed thought that they

could not lose money in government bond funds. Another study on the

financial literacy of mutual fund investors found that less than half of all

investors correctly understood the purpose of diversification. Further,

SEC reported that over half of all Americans do not know the difference

between a stock and a bond, and only 16 percent say they have a clear

understanding of what an IRA is.

Although individuals who currently make investment decisions are likely

to have some familiarity with investing, education would also be important

for them because of their increased responsibility under an individual

account program. Furthermore, according to the studies cited above,

there would be a real need for enhanced education about such topics as

investing, risk and return, and diversification. As the Chairman of SEC

has said, there is a wide gap between financial knowledge and financial

responsibilities. Closing that knowledge gap is imperative under an

individual account program.

Moving to an individual account program is going to require a thorough

education effort for everyone to understand the program and how it is

different from the current Social Security program. The government has

much more responsibility for educating individuals under a mandatory

program because people would effectively be forced by the government to

save and to make decisions about what to do with that saving as well as

bear the consequences of a decision. Even with a default option for those

who do not choose to participate, the government needs to explain why

the option was provided and what are its implications.

 

12 See studies such as the Securities Industry Association, “1997 Annual SIA Investor Survey: Investors’

Attitudes Towards the Securities Industry, November 1997, and Vanguard Group, “Vanguard/Money

Mutual Fund Literacy Test,” January 1998, and Office of Investor Education and Assistance Securities

and Exchange Commission, “The Facts on Saving and Investing,” February 24, 1998.

Education Is Also Important for

Those Individuals Who

Currently Make Investment

Decisions

Enhanced Education Is

Important for Individual

Accounts Program
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 60 GAO/GGD-99-115 Issues Associated With Individual Accounts

Many people do not understand the current Social Security program, how

their contributions are measured, and how their benefits are computed,

even though the program is over 60 years old. Yet, millions of individuals

rely on the program as their sole source of retirement income. In order to

increase people’s understanding of Social Security, SSA has implemented

various efforts to educate people. Such efforts have included providing a

1-800 number for recipients to ask questions, having a public education

service campaign, and providing educational packages to individuals.

Despite these efforts, SSA officials said that people still have a hard time

understanding the program. Implementing an individual account program

is likely to require enhanced education not only about individual accounts

but also about how an individual account program would change the

nature of Social Security and what that means for the individual.

At a minimum, under an individual account program, educational efforts

would be needed to help people understand how individual accounts

would work and how the accounts would affect their retirement income

security. Many proposals do not specify what entity would be responsible

for the public education program that would be needed for an individual

account program. On the basis of the type of information experts13 in

employee education say is needed, education about an individual account

program could include the following information:

• Goals of the program — individuals need to know what the goals of the

program are and why they are participating.

• Responsibilities — individuals need to know what their responsibilities are

under the program.

• Retirement Income — individuals need to know what their retirement

income needs are and how their retirement needs will be affected under an

individual account program.

• Materials — individuals need materials that convey the message of the

program and what will be required of them.

The amount of education that would be necessary under an individual

account program depends on the range and type of investment choices

offered to individuals. There are basic issues that individuals will need to

be educated about regardless of how the program is structured. Such

issues include (1) the choices they have to make; (2) the consequences of

those choices; (3) what the investment options are, such as stocks, bonds,

 

13 See Richard D. Glass, “Investment Education: Who’s Fooling Whom?” Employee Benefits Journal,

March 1999, pp. 3-8; and George Loewenstein, “Costs and Benefits of Health and Retirement Related

Choice,” Paper for the Eleventh Annual Conference of the National Academy of Social Insurance,

January 8, 1999.

Amount of Education

Necessary is Directly

Linked to the Choices

Offered
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 61 GAO/GGD-99-115 Issues Associated With Individual Accounts

and indexed mutual funds; (4) rates of return of different investment

vehicles; and (5) the risks of investment vehicles. However, as a wider

variety of choice is offered to individuals, more education beyond the

basics would be necessary because broader issues would need to be

considered. With more variety of choice, investors would need to choose

among various assets, which requires the investor to have certain skills to

evaluate the risks and his or her own preference for risks. If the structure

allows for an even broader variety of choices such as real estate, the

educational requirements would mount. When choices are limited to a few

well-diversified choices (such as a few indexed mutual funds), many

decisions are made by those managing the funds or by rules governing the

fund (such as what an indexed mutual fund can invest in). If the investor

has the option of frequently moving funds from one investment to another,

the educational effort needs to include analytical tools to aid such

decisions and advice about the importance of a long-term horizon. Thus,

the fewer well-diversified choices offered, the less risk to the individual

and the more targeted the education could be.

Investment options Education needed

More investment choices offered More broad-based education that is needed

Fewer investment choices offered Less education, but more targeted

Source: GAO

A variety of choices may benefit people in that it offers them a wider

selection from which to choose, allowing them to choose the option that is

in line with their preferences. However, it also increases their risk in that

they could potentially choose less diversified investments, such as

individual equities, that could result in financial loss. Furthermore, the

wider the variety of choice offered, the greater the need for people to

consider other issues. For instance, because offering a wide variety of

investment options is likely to promote competition among financial

institutions to provide a range of investment vehicles, investors would

need to be educated about fraud and how to avoid it. When Great Britain

went to an individual account program, individuals purchased unsuitable

investments because of high-pressured sales tactics that resulted in

individuals losing billions of dollars. The Chairman of the SEC has stated

that allowing a broad range of investment options under individual

accounts provides opportunities for fraud and sales practice abuses.

Thus, education about fraud becomes important. For example, an investor

would need to know what to look for, what type of questions to ask, what

type of advice is biased, what the investor’s rights are, or what the law

requires. When investment options are limited, the chances of fraud are

reduced.

Table 4.1: Investment Choices Under an

Individual Account Program and the

Education Required

More Investment Choices, More

Education
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 62 GAO/GGD-99-115 Issues Associated With Individual Accounts

Moreover, the wider the variety of choice that is offered individuals, the

more they will need education about understanding the value of

diversification and the possible consequences of not having a diversified

portfolio. If choices are limited to indexed mutual funds, less education

about diversification would be needed because indexed funds are by

nature diversified.

Education is also necessary for understanding risks and the various

returns that are likely with different investment options. With a wider

variety of investment options, understanding risk and being able to manage

the risk become important. It is important to explain to people that

historical returns may not always be good predictors of future returns,

especially when risks are ignored. As stated in chapter 3, measuring risk

and comparing risk-adjusted returns can be a difficult process.

Furthermore, being able to understand the rates of returns of various

options and pick the appropriate investment vehicles become more

difficult, as more variety is offered. Individuals would need more expertise

to understand differences in the rates of return of equities, bonds, equity

mutual funds, indexed funds, and so on.

If the program has fewer well-diversified choices, limits would be placed

on the ways that people could lose money. The educational effort could,

therefore, focus more on getting individuals to be informed participants in

the program. Educational issues that become relevant when individuals

are offered numerous options are of less concern when they are offered

fewer, well-diversified options.

With fewer, well-diversified investment choices, the educational effort

could be more targeted to the purpose of retirement savings, e.g.,

educating people about how much they would need to save and invest for

retirement or determining their goals for retirement. Other issues, such as

compounding—the calculation of interest earned on a daily, quarterly,

semiannual, or annual basis—or the impact of inflation on returns are

issues that individuals need to fundamentally understand. For example,

with compounding interest individuals could earn interest on the money

they save and on the interest that the money earns, e.g., if they invested

$1,000 at 3-percent interest they could double their money in 24 years, but

at 4 percent interest they could double it in 18 years. With inflation, or

rising prices, the money that individuals earn on their investments would

potentially be worth less and less as prices rose. In addition, seemingly

small annual fees can eat away at the accumulated value. Offering fewer,

more well-diversified options enables the education effort to be targeted

Fewer Investment Choices, Less

Education Needed
Chapter 4

Enhanced Education is Necessary for an Individual Account Program

Page 63 GAO/GGD-99-115 Issues Associated With Individual Accounts

on basic issues that would be helpful for individuals to understand in order

to save for retirement.

Despite current efforts to increase people’s awareness to save more, many

people are still not saving and making the retirement choices they need to

make, effectively relying on Social Security to be their primary source of

retirement income. It is unlikely that moving to individual accounts will

result in active participation by all individuals. Thus, various officials have

suggested that a default option be provided for those individuals who,

regardless of educational effort, will not make investment choices.

Default options could include a default to the defined benefit portion of

Social Security (staying in the current Social Security program) or to some

type of mandatory allocation. One example would be an investment

vehicle in which, depending on the age of the individual, certain portions

of the investment could be in equities and certain portions in bonds. The

portion in bonds would increase with the age of the individual.

Alternatively, the default option could be invested totally in Treasuries. As

with any option, a default option with less risk is also likely to provide

lower returns.

Default Option
Appendix I

Comments From the Social Security

Administration

Page 64 GAO/GGD-99-115 Issues Associated With Individual Accounts
Appendix I

Comments From the Social Security Administration

Page 65 GAO/GGD-99-115 Issues Associated With Individual Accounts
Appendix II

GAO Contacts and Staff Acknowledgments

Page 66 GAO/GGD-99-115 Issues Associated With Individual Accounts

Tamara E. Cross, (202) 512-4890

Lawrence D. Cluff, Thomas H. Givens III, Mitchell B. Rachlis, John

Schaefer, George Scott, Kenneth Stockbridge, Paul Thompson

GAO Contact

Acknowledgments
Page 67 GAO/GGD-99-115 Issues Associated With Individual Accounts
Page 68 GAO/GGD-99-115 Issues Associated With Individual Accounts
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