SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

2

U.S. DEPARTMENT OF THE TREASURY

ISSUE BRIEF NO. 4

SOCIAL SECURITY REFORM:

MECHANISMS FOR ACHIEVING 

TRUE PRE-FUNDING

INTRODUCTION

This is the fourth in a series of Treasury issue briefs on Social Security reform. It expands on a point 

introduced in the second issue brief; namely, that making Social Security reform fair to future generations 

requires building up and safeguarding resources in the near term that can be used to fund future benefi ts 

as the number of retirees per worker increases. As was discussed in the second brief, there is nothing 

currently in place to prevent current contributions in excess of current benefi ts from being unwound by 

larger defi cits in the non-Social Security portion of the federal budget. This brief reviews the need for 

true pre-funding and its implications for reforms that achieve a fi nancially sustainable Social Security 

system. The brief then analyzes possible mechanisms to help ensure that attempted pre-funding is in fact 

real pre-funding.

The institutional reforms considered in this issue brief, including several variants of personal accounts, are 

discussed solely in terms of the contribution they make to ensuring that attempts to pre-fund Social Security actually result in an accumulation of resources to fund future benefi ts. Accordingly, elements of these 

reforms that do not directly bear on the question of pre-funding—for example, the inheritability of personal accounts—are not discussed. In addition, it should be emphasized at the outset that none of the 

mechanisms for pre-funding considered here involve the privatization of any function of Social Security.

FAIR REFORM REQUIRES SUBSTANTIAL PRE-FUNDING

The connection between fairness and the need for pre-funding is straightforward. As shown in 

Figure 1, the old-age dependency ratio—the ratio of retirees to workers—is expected to rise rapidly over 

the next thirty years and then to rise slowly but steadily in every year thereafter. This pattern refl ects the 

imminent retirement of the relatively large baby-boomer birth cohorts together with projected sustained 

improvements in longevity. This demographic shift has important implications for Social Security, since 

the revenues of the system take the form of contributions paid by workers while expenditures go largely 

to retirees (as in previous briefs, the discussion here focuses on the retirement portion of Social Security 

rather than on disability benefi ts).
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0

5

10

15

20

25

30

35

40

45

Percent

Figure 1: Persons Aged 66 and Over 

per 100 Persons Aged 15 to 65

2005 Trustees Report Projections

Source: Social Security Administration

Year

1975 1985 1995 2005 2015 2025 2035 2045 2055 2065 2075 2085 2095

In these circumstances, any reform of Social Security that makes the system permanently solvent and that 

seeks to maintain contributions and benefi ts at some stable fraction of people’s wages while working 

must accumulate resources in the near term when there are relatively more workers (that is, when the oldage dependency rate is relatively low) so as to help fi nance benefi t payments in later years when there 

are relatively more retirees (that is, when the old-age dependency rate is relatively high). This accumulation of resources is known as “pre-funding,” and is accomplished by having current revenues exceed 

expenditures and by safeguarding the resulting surpluses so that they provide resources with which to 

fund future benefi ts. If instead no attempt is made to pre-fund future benefi ts, then it will be necessary in 

a solvent system to reduce benefi ts for the cohorts of retirees that are relatively large and/or to require 

higher contributions from the later, relatively small cohorts of workers who are paying for the retirement 

benefi ts of the earlier cohorts. Either outcome would be viewed as unfair by most people because it 

causes the net value of Social Security to vary across birth cohorts depending on their size.

The amount of pre-funding that is needed depends on both demographics and the size of benefi ts to 

be afforded to future retirees. A convenient reference point for assessing the rough magnitude of prefunding that would occur under a fair Social Security reform plan is given by the amount of planned 

pre-funding under the “Nonpartisan Reform Plan” that was recently proposed by Jeffrey Liebman, Maya 

MacGuineas, and Andrew Samwick.1 That plan calls for cuts to defi ned benefi ts that are partly made 

up by benefi ts payable from mandatory personal retirement accounts, and brings more revenue into the 

system by raising the maximum taxable earnings threshold and requiring that individuals make some outof-pocket contributions to their retirement accounts.

1 For a description of the Nonpartisan Reform Plan and a link to the Social Security Administration’s scoring of it, see 

http://www.nonpartisanssplan.com/pages/1/index.htm. The plan is used here strictly for illustrative purposes; this 

discussion does not represent an endorsement or a policy proposal.
SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

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U.S. DEPARTMENT OF THE TREASURY

The Nonpartisan Reform Plan involves signifi cant planned pre-funding. This can be seen from 

Figure 2, which gives the projected time profi le of contributions in excess of benefi t payments (expressed 

as a share of GDP) implied by the plan. (Both contributions and benefi ts include the contributions and 

benefi ts that are attributable to the plan’s personal retirement accounts.) Annual planned pre-funding 

under the plan would be about 1 percent of GDP between 2008 and 2018 and would slowly decline 

thereafter, with negative pre-funding starting in 2034 as resources are used to pay benefi ts. To put the 

magnitude of this planned pre-funding in perspective, note that it is equivalent to putting aside 15.5 percent of GDP in 2007 to help pay benefi ts after 2034; by comparison, past attempted pre-funding from 

the inception of Social Security to 2007—the accumulated value of all past Social Security surpluses—

corresponds to 16.4 percent of 2007 GDP.

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2005 2015 2025 2035 2045 2055 2065 2075

Percent

Figure 2: Annual Attempted Prefunding Under the Nonpartisan Reform Plan 

(Current Contributions in Excess of Current Benefits Paid As Share of GDP, 

Based on 2005 Trustees Report Assumptions)

Source: Social Security Administration Year

Current-Law Scheduled

Benefits and Taxes

Nonpartisan Reform Plan 

(Budget Surplus + Personal Account Surplus)

Other Social Security reform plans call for less planned pre-funding than the Nonpartisan Reform Plan; 

this can be done by reducing benefi ts and/or increasing contributions relatively more gradually. In both 

cases, the effect is to impose a larger share of the Social Security reform burden on distant future generations. To assess whether the Nonpartisan Reform Plan provides a reasonable guide to the appropriate

level of pre-funding, therefore, Figure 3 shows how the plan distributes Social Security’s reform burden 

across birth cohorts as measured by the lifetime net benefi t rate. As is explained in Treasury’s second 

and third issue briefs, the lifetime net benefi t rate is defi ned as the present value of net lifetime Social 

Security benefi ts (benefi ts less taxes) as a percentage of the present value of the individual’s lifetime 

wages. The lifetime net benefi t rate for a birth cohort is the same as that for an individual except that 

the numerator (net Social Security benefi ts) and the denominator (lifetime wages) are sums computed 

over all members of the birth cohort.
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-5

-4

-3

-2

-1

0

1940 1960 1980 2000 2020 2040 2060 2080 2100

Figure 3: Lifetime Net Benefit Rates by Birth Cohort

Under Current Law and Nonpartisan Reform Plan Percent

Source: Department of the Treasury

Year of Birth

Current-Law Scheduled 

Benefits and Taxes

Nonpartisan Reform Plan

Figure 3 shows that the Nonpartisan Reform Plan’s provisions are fully phased in beginning with the 

1995 birth cohort.2 After the 1995 birth cohort, the lifetime net benefi t rate creeps upward as life expectancies rise for successive birth cohorts, which results in their receiving benefi ts over a longer period 

of time. On this score, it is noteworthy that the plan probably does not achieve permanent solvency, 

but likely would do so if it were modifi ed to include benefi t reductions that offset the effect of increasing 

longevity on the value of lifetime benefi ts beginning with the 1996 birth cohort. Such a modifi cation 

would not change the amount of planned pre-funding under the plan, but would result in a fl at lifetime 

net benefi t rate starting with the 1995 birth cohort. As was discussed in Treasury’s third issue brief, a 

lifetime net benefi t profi le that is fl at in the long run is arguably fairer than one that forever rises.

Whether pre-funding under this plan is too small or too large depends on one’s judgment as to how 

quickly a Social Security reform should be phased in. This particular plan is fully phased in starting with 

the 1995 birth cohort, whose members are 13 years old when the plan’s reforms are assumed to begin. 

If a more rapid phase-in were desired, then planned pre-funding would be larger and future generations 

would be made better off at the expense of current generations; similarly, if a less rapid phase-in were 

desired, then planned pre-funding would be smaller and current generations would be made better off 

at the expense of future generations.

WHAT HAPPENS WHEN PLANNED PRE-FUNDING IS NOT REAL?

Pre-funding is an effective fi nancing strategy provided that the near-term surplus revenues are safeguarded in a way that allows them to be used to pay for future benefi ts. The present Social Security system 

has its surpluses accumulate in the trust fund. These surpluses will increase the government’s capacity 

2 The Nonpartisan Reform Plan’s benefi t reductions end with the 1988 birth cohort, but rules concerning the share of personal account contributions that are made out-of-pocket make the accounts decreasingly generous for birth cohorts born 

between 1986 and 1997. 
SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

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U.S. DEPARTMENT OF THE TREASURY

to pay benefi ts in the future only to the extent that they result in smaller amounts of public debt issuance 

than would occur if there were no surpluses. This is because reducing near-term public debt issuance 

would increase the government’s capacity to issue debt in the future to help pay benefi ts when the 

bonds in the trust fund are redeemed.

Many analysts believe that Social Security surpluses under the present system do not increase the 

government’s capacity to pay future Social Security benefi ts. Under this view, Social Security surpluses 

are offset in the rest of the federal budget by some combination of higher non-Social Security spending 

and/or lower non-Social Security taxes. To the extent that this is true, Social Security’s surpluses do not 

increase the government’s capacity to pay future Social Security benefi ts. The future benefi t payments 

that would have been fi nanced with public debt issuance had Social Security surpluses truly been saved 

must instead be fi nanced with lower non-Social Security spending and/or higher non-Social Security 

taxes. In this case, the existence of the near-term Social Security surplus causes the non-Social Security 

budget to be more profl igate, and the future Social Security cash defi cit will require future non-Social 

Security budgets to have either higher taxes or lower spending than would have been the case had 

today’s surpluses resulted in true pre-funding. Under this scenario, an attempt to make Social Security 

fair to future generations by accumulating near-term surpluses in the trust fund would be undone by a 

non-Social Security policy that is less fair to future generations. Rather than resulting in resources that 

provide future benefi ts, running a Social Security surplus today would instead lead to more debt outside 

the trust fund that must be paid off by future generations, leaving them with no net gain.

WHAT NEEDS TO BE UNDERSTOOD FOR SOCIAL SECURITY 

SURPLUSES TO BE SAVED?

In order for Social Security surpluses to be saved, taxes and spending in the non-Social Security portion 

of the budget must be set with the recognition that the special-issue government securities held by the 

trust fund represent liabilities that are every bit as real and important as debt held by the public. While 

the non-Social Security budget must ultimately redeem those special-issue securities in any case, it is only 

when they are recognized as equivalent to publicly held debt that the non-Social Security budget will 

plan in advance for their redemption by using Social Security surpluses to reduce public debt issuance. 

When used to lower publicly held debt today, the surpluses increase the government’s capacity to issue 

publicly held debt to pay for Social Security benefi ts in the future. Otherwise, those future benefi ts must 

be fi nanced with lower non-Social Security spending or higher non-Social Security revenues.

The meaning of this can be illustrated using actual budget numbers for a particular year. Table 1 shows 

how federal fi nances in the 2006 fi scal year can be divided into a Social Security component and 

a non-Social Security component. In that year, the unifi ed budget defi cit was $248 billion, and was 

comprised of a $185 billion Social Security surplus and a $433 billion non-Social Security defi cit. Debt 

held by the public at the beginning of the year was $4.6 trillion, and was comprised of a $6.4 trillion 

non-Social Security obligation and a $1.8 trillion Social Security credit. Interest on the non-Social Security obligation puts its size in perspective; in the year shown, it was $324 billion, which is 18 percent as 

large as non-interest non-Social Security outlays.

When looking at Table 1, the pertinent question is whether the $109 billion non-Social Security defi cit 

excluding interest (the primary defi cit) was entered into with the full understanding that a $6.4 trillion 

debt was outstanding that must be serviced exclusively with non-Social Security revenues, or whether the 

$185 billion loan made by Social Security to the non-Social Security budget was viewed as an ongoing unconditional grant, with grants of that magnitude assumed to persist into the indefi nite future. 
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SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

In the latter case, the non-Social Security defi cit is larger than it would have been had the Social Security surpluses not existed; Social Security surpluses are therefore not wholly saved.

FOUR STRATEGIES TO INCREASE THE LIKELIHOOD THAT PLANNED SOCIAL 

SECURITY PRE-FUNDING REPRESENTS REAL PRE-FUNDING

This section analyzes four strategies to help ensure that planned Social Security pre-funding is in fact real 

pre-funding. Ordered from most aggressive and most likely to work to least aggressive and least likely 

to work, the strategies are as follows.

Strategy 1. Pre-fund in full-service personal accounts.

Strategy 2. Pre-fund in bare-bones accounts administered by a quasi-governmental entity.

Strategy 3. Invest the Social Security trust fund in private-sector assets.

Strategy 4. Invest the Social Security trust fund in marketable federal debt.

STRATEGY 1: PRE-FUND IN FULL-SERVICE PERSONAL ACCOUNTS

If current trust fund accumulations do not represent true saving, it is because the special-issue government 

securities that are held by the trust fund are not regarded as liabilities to the non-Social Security budget 

that are as real and important as debt held by the public, despite the fact that these securities will ultimately be redeemed. In that case, introducing personal accounts to Social Security would remedy this 

problem by effectively converting the special-issue government securities into publicly held debt.

To see how this occurs, consider the following simple exercise. Start from any Social Security reform 

without accounts that makes Social Security permanently solvent, and imagine modifying the plan to 

Table 1

Fiscal Year 2006 Federal Finances 

In Billions of Dollars

Social Security Non-Social Security Unified

Primary Surplus 87 -109 -22

Interest Received* 98 -324 -227

Total Surplus 185 -433 -248

Debt Held by Public

 End of Fiscal 2005 -1,809 6,401 4,592

 End of Fiscal 2006 -1,994 6,823 4,829

* Interest received is entered as a positive number; interest paid is entered as a negative number.

Source: Historical Tables, Budget of the U.S. Government.
SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

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U.S. DEPARTMENT OF THE TREASURY

allow one individual to direct $1,000 of his or her payroll tax payments to a personal account in exchange for reducing his or her future defi ned benefi ts in an actuarially fair manner. For this simple case, 

it will be shown that 1) the personal account will have no direct effect on the government’s underlying 

fi scal condition; and 2) the account would better reveal the true state of fi scal policy and might thereby 

result in smaller non-Social Security defi cits being chosen.

The Personal Account’s Direct Effect on the Government’s Fiscal Condition

The personal account’s effects on the time profi le of publicly held federal debt and the unifi ed defi cit are 

shown in Figures 4 and 5, respectively.3 The example assumes that the individual is 45 years old at the 

time of the personal account contribution, begins collecting benefi ts as a single person at age 65, and 

is certain to die at age 85; and that the real government borrowing rate is always 3 percent. In this 

case, then, the actuarially fair reduction in defi ned benefi ts is $121 per year.

0

200

400

600

800

1000

1200

1400

1600

1800

2000

45 50 55 60 65 70 75 80 85

Real Dollars

Source: Department of the Treasury Age of Participant

Figure 4: Effect on Publicly Held Debt of a One-Time $1000 Contribution 

to an Actuarially Fair Personal Account at Age 45

3 The profi le for the unifi ed defi cit shown in Figure 5 is the annual change in the level of publicly held debt shown in 

Figure 4.
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-200

0

200

400

600

800

1000

1200

45 50 55 60 65 70 75 80 85

Real Dollars

Figure 5: Effect on the Unified Deficit of a One-Time $1000 Contribution 

to an Actuarially Fair PRA at Age 45

Source: Department of the Treasury Age of Participant

At the time of the $1,000 account contribution, when the contributor is age 45, government outlays are 

increased by $1,000 and government revenues are unchanged, so the increment to publicly held debt is 

$1,000. Between the ages of 45 and 65, the increment to real publicly held debt rises at a 3 percent 

rate (the assumed real government borrowing rate) because the incremental debt must be continually rolled 

over. After the contributor retires at age 65, annual defi ned benefi t payments are reduced by $121 (this 

amount is made up by the benefi ts paid from the personal account); this reduction in defi ned benefi ts 

results in a smaller unifi ed defi cit (Figure 5), which in turn causes the increment to publicly held debt to 

steadily decline (Figure 4). When the person dies at age 85, the increment to publicly held debt is precisely zero, which is what it means in this context for the defi ned benefi t reductions to be actuarially fair. 

Figure 4 demonstrates that adding actuarially fair personal accounts to a reform plan that is permanently 

solvent results in a plan that is also permanently solvent. But while actuarially fair accounts do not compromise permanent solvency, they do cause near-term unifi ed defi cits and publicly held debt to increase. 

The presence of this increment to near-term debt levels—which is often referred to as transition debt—is 

sometimes enlisted as an argument against instituting personal accounts.4 In fact, “transition debt” does 

not represent a new obligation of the government, it merely substitutes publicly held debt for an existing 

implicit debt—namely, the obligation to pay defi ned benefi ts. Total government obligations are left unchanged at every point in time, which implies that the incremental public debt profi le shown in Figure 4 

is exactly matched by the time profi le of reductions in the present value of defi ned benefi t promises. (It 

is also true that the increase in publicly held debt is exactly matched by a reduction in the special-issue 

government securities held by the trust fund.)

4 While transition debt associated with each individual’s account is ultimately zero, total transition debt would always be 

positive for an ongoing Social Security system with personal accounts. In the hypothetical situation where accounts are 

invested exclusively in government debt, transition debt is simply equal to aggregate account balances; in an ongoing 

Social Security system, such balances will always be positive. Hence, the term “transition debt” is a misnomer for two 

reasons: It does not represent an addition to government liabilities, and it is not merely transitory.
SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

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U.S. DEPARTMENT OF THE TREASURY

Substituting explicit public debt for an existing implicit debt should in principle have little impact on 

fi nancial markets. This is most obvious in the case where personal accounts are invested in federal 

government bonds and are paid out as actuarially fair real annuities, and where the accounts’ administrative costs are kept low. In that case, introducing actuarially fair accounts as described here leaves 

total benefi t levels essentially unchanged; all that occurs is that participants hold federal debt, an explicit 

government obligation, in lieu of defi ned benefi t promises, an implicit government obligation. Because 

the accounts are invested in federal debt, they absorb all the increment to publicly held debt and there is 

no pressure for market interest rates to change. 

The story is more complicated if personal accounts are invested in assets other than federal debt. In that 

case, the annual increase in purchases of private assets (equal to the account contributions) is precisely 

matched by the annual increase in public debt, so accounts increase the supply and demand for fi nancial assets by precisely the same amounts. Any effect on interest rates should therefore be modest.5

These conclusions have been arrived at for what might seem to be a special case—one in which personal 

accounts are an actuarially fair modifi cation to a permanently solvent plan that includes no accounts. As 

Box 1 explains, however, these conclusions in fact apply to any plan that includes personal accounts.

5 The point here is that the economic fundamentals determining interest rates are not changed when explicit public debt 

is substituted for implicit obligations to pay defi ned benefi ts. That said, if market participants fail to understand this—for

example, if they were to believe that changes in publicly held debt have a larger effect on interest rates than do 

changes in implicit debt—then such a policy change would temporarily affect asset prices and interest rates. Eventually, 

however, market perceptions must come into alignment with underlying economic reality—deviations of market rates 

from fundamentals will not be permanent.

BOX 1

A CONCEPTUAL FRAMEWORK FOR UNDERSTANDING THE 

EFFECTS OF PERSONAL ACCOUNTS

This brief isolates the effects of personal accounts on solvency and benefi t levels by beginning with a Social 

Security system without accounts and then introducing actuarially fair personal accounts. This analytical framework 

clearly applies to reform plans whose personal accounts are described as actuarially fair. For example, plans with 

voluntary personal accounts that are funded with payroll tax revenues have two components: (1) defi ned benefi ts 

if there were no personal accounts; and (2) diversions of payroll tax revenues to personal accounts and offsets to 

defi ned benefi ts for those choosing a personal account. These plans conform to the analytical framework used 

here to analyze the effects of personal accounts if the defi ned benefi t offsets are actuarially fair.

But the effects of personal accounts that are derived using this framework and discussed in the body of the brief 

apply to any plan that includes personal accounts, not just those that describe the accounts as being actuarially fair. 

To see that this is true, consider the hypothetical example given by the table below. The fi rst two columns of fi gures 

(labeled columns 1 and 2) relate to “Plan A,” in which a worker has the option of putting some of his or her payroll 

taxes into a personal account. If a personal account is not elected, column 1 indicates that defi ned benefi ts are $95 

and payroll taxes are $100. Alternatively, if a personal account is elected, column 2 indicates that $10 of payroll 

taxes are diverted to a personal account and defi ned benefi ts are reduced by $5. Because the defi ned benefi t offset is less than the payroll tax diversion, the personal account as described is more than fair to the worker. To focus 

on the effects of personal accounts, assume that the personal account is elected (this could equally describe a hypothetical plan with a mandatory account as in column 2). With the account chosen, Plan A is described in column 2: 

defi ned benefi ts are $90, payroll taxes are $100, and $10 of payroll taxes are diverted to a personal account. 
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SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

The effect of personal accounts in Plan A is the difference between the effects of that plan and the effects of a 

comparable plan that includes only defi ned benefi ts. For this purpose, the comparable defi ned-benefi t-only plan 

is a modifi cation of Plan A that diverts each person’s $10 personal account contribution to the trust fund and 

increases their defi ned benefi ts by the maximum amount possible while keeping the plan’s long-run actuarial balance unchanged. The resulting plan, “Plan B,” is shown in the third column of the table; it boosts defi ned benefi ts 

by $10 relative to Plan A. It is apparent, therefore, that Plan A with accounts selected (or mandatory) is just Plan B 

plus actuarially fair personal accounts. So the effect of Plan A’s personal accounts is found by comparing a plan 

without personal accounts—Plan B—with the same plan modifi ed to include actuarially fair personal accounts—

Plan A. This is precisely the analytical framework utilized in the brief.

Some analysts mistakenly infer the effects of personal accounts by comparing columns 1 and 2 in the table. The 

reasoning is that within the context of how the plan is described, electing an account moves an individual from 

column 1 to column 2, so the effect of the accounts is naturally associated with the effect of moving between these 

two columns. Under this way of thinking, the personal account increases total benefi ts (defi ned benefi ts plus benefi ts payable from personal accounts) by $5 and worsens Social Security’s long-run actuarial balance by $5. But 

the same outcome could be achieved simply by boosting defi ned benefi ts by $5; hence, this interpretation does 

not properly isolate the effects of the accounts as they differ from the effects of a defi ned benefi t change that costs 

the same amount.

It should be noted that because any Social Security reform plan with personal accounts can be conceptualized as 

a defi ned-benefi t-only plan combined with actuarially fair personal accounts, it is not really meaningful to assess 

the degree to which personal accounts contribute to making Social Security permanently solvent as traditionally 

measured. True solvency requires the system’s infl ow and outfl ow over the indefi nite future to be in balance in 

present-value terms (the traditional solvency measure), and also requires attempted pre-funding to be real pre-funding. Personal accounts do not help to improve the traditional solvency measure, but they would help to ensure that 

attempted pre-funding is real.

Table 2

Isolating the Effects of Personal Accounts for a Plan

That Describes Them as Being More Than Fair

Plan with Personal Accounts (Plan A) Comparable Plan 

Without Personal 

Accounts (Plan B) 

Item (3)

If Personal 

Account Not Elected 

(1)

If Personal 

Account Is Elected 

(2)

Defined Benefits 95 90 100

Payroll Taxes 100 100 100

Diversion of 

Payroll Tax to 

Personal Account

— 10 —

Memo:

Implied Defined

Benefit Offset — -5 —
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The Effect of Personal Accounts on the Conduct of Fiscal Policy

The discussion thus far suggests that introducing actuarially fair, conservatively invested personal 

accounts to a permanently solvent Social Security system in which accounts are initially absent carries 

no important consequences: Accounts do not directly change the time profi le of the government’s total 

liabilities; they should have little or no direct impact on fi nancial markets; and they would have little 

effect on benefi t levels.

However, the essential point of making personal accounts part of Social Security is to better reveal the 

state of the government’s budget so that more prudent fi scal policy decisions are made outside of Social 

Security. Specifi cally, by transforming implicit promises to pay future Social Security benefi ts into explicit 

quantities of publicly held debt, personal accounts could result in smaller non-Social Security fi scal defi -

cits today. To the extent that this is true, personal accounts are benefi cial rather than merely benign as 

they would indirectly reduce the time profi le of total government liabilities, thereby improving the well-being of future generations and putting downward pressure on interest rates. 

What Role Does the Equity Premium Play?

Some analysts argue that personal accounts would also make Social Security more generous by giving 

participants access to equity returns that are normally higher than the returns earned on trust fund investments. This argument is fl awed for two reasons, however. First, while equities do have an expected 

return that is greater than that offered by government bonds, the additional expected return (the socalled “equity premium”) comes at the cost of assuming a larger amount of risk. To the extent that the 

equity premium merely compensates for this additional risk, cashing in a bond and buying equities does 

not make an investor any better off. In this case, the value of personal accounts is well approximated 

by their value when they are invested exclusively in government debt; hence, the presence of accounts 

would make Social Security no more or no less generous. A second and perhaps more compelling 

point concerns aggregate private-sector portfolio returns. Because personal accounts have no direct 

effect on national saving (as opposed to the indirect effect that they might have through fostering greater 

fi scal discipline), equities held in the accounts simply displace equities that would otherwise be held 

elsewhere in the consolidated portfolio of the private sector. Thus, accounts can only change the distribution of equity returns across the population, not total equity returns in the economy.

Equity returns do nevertheless have some relevance for assessing the advantages of personal accounts. 

First, to the extent that the accounts lead to smaller non-Social Security defi cits, they result in an increase 

in government saving that boosts national saving and national wealth. The returns that would be earned 

on the additional national wealth are closely connected to the return on equities. Second, while the 

direct effect of personal accounts is to merely redistribute aggregate equity returns across the population, 

that redistribution could itself be benefi cial. Although it is true that investors who wish to accumulate safe 

assets at a pace at least as rapid as the rate at which Social Security’s defi ned benefi t accrues should 

be indifferent to whether their personal accounts are invested in equities or bonds, young individuals 

with little fi nancial wealth probably do not fi t that description. Because many young people’s primary 

access to equity investments would come through their personal accounts, their fi nancial well-being 

would suffer if their personal account investments were restricted to bonds alone.
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SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

Administrative Costs Under Full-Service Personal Accounts

An important downside of full-service personal accounts is that they would substantially increase the 

costs of administering Social Security. Even if such accounts could be administered as effi ciently as the 

current defi ned contribution plan for federal employees (the Thrift Savings Plan), a recent CBO study 

estimated that annual administrative costs would be $25 per participant (in 2004 dollars), which would 

raise the overall cost of administering Social Security to about three times its current level.6 If accounts 

were to receive contributions equal to 2 percent of wages, the study estimated that administrative costs 

of this magnitude would reduce account balances at retirement by about 5 percent.

STRATEGY 2: PRE-FUND IN ACCOUNTS OFFERING NO INVESTMENT CHOICES AND 

ADMINISTERED BY A QUASI-GOVERNMENTAL ENTITY

In order to keep the administrative costs of accounts very low, it would be possible to create bare-bones 

accounts administered by a quasi-governmental entity like the Federal Reserve System. Such accounts 

might be invested exclusively in federal debt, or might include private-sector assets, but in either case 

investments would be pooled and no investment choice would be permitted. Without any investment 

choice, administrative costs would be very low because customer service would be limited to an annual 

account statement and a payout determination at retirement.7

A Social Security system consisting of bare-bones accounts and an ordinary defi ned benefi t component 

could be designed to closely match benefi t payments made by a defi ned-benefi t-only system. Again, 

it is useful to imagine starting from a defi ned-benefi t-only system that is permanently solvent—call this 

System A—and then introducing actuarially fair accounts (as in the discussion above) to arrive at a new 

system, System B. The System B accounts would be invested exclusively in government debt and would 

be paid out as real annuities. Because there would be no investment or payout choice, administrative 

costs would be very small and total benefi ts could be essentially the same as in System A. With such 

accounts, it should be clear that contributions made to the accounts are not available to fi nance nonSocial Security programs. Similarly, it should be clear that the debt held by the accounts’ administrator 

represents claims on the non-Social Security budget that are no different than other publicly held debt. 

Investing accounts exclusively in federal debt would reduce risk and ensure that a reform plan that 

includes accounts could pay benefi ts that closely match the benefi ts that would be paid by any given 

defi ned-benefi t-only system. Some, however, might prefer the higher expected returns offered by a 

riskier portfolio, even though there would be some chance that the portfolio’s return would be lower than 

that offered by federal debt.8 

6 Congressional Budget Offi ce, “Administrative Costs of Private Accounts in Social Security,” March 2004.

7 Another advantage of accounts with no investment choice is that the current time lag between when employers make 

payroll tax payments and when those payments are allocated to individuals (which can be as long as 18 months) 

would be of no consequence, as allocated and unallocated funds would be invested in the same way.

8 A possible disadvantage of investing accounts exclusively in federal debt is that policymakers would perceive that 

the accounts’ administrator is a captive buyer of federal debt whose existence reduces the cost of issuing public debt. 

However, a contrary view is that what matters to policymakers when deciding defi cit levels is the government borrowing 

rate; as discussed in the text, that rate should be little affected by how the accounts are invested. 
SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

14

U.S. DEPARTMENT OF THE TREASURY

Budgetary Treatment Issues

How personal accounts would affect offi cial measures of defi cits and debt depends on whether the 

accounts are judged to be owned by individuals or by the government. The Offi ce of Management 

and Budget (OMB) would determine the status of accounts based on the source of funds, legal terms of 

ownership, and control over use and disposition of the accounts. One important criterion for the privateproperty designation under current budgeting rules would be that an individual’s defi ned benefi ts not 

be too closely linked to the individual’s personal account balance. This would rule out the possibility 

that the reduction in each individual’s ordinary defi ned benefi ts would be set equal to the annuity value 

of his or her account balance at retirement, as was assumed in the illustration given above of actuarially fair accounts.9 If that possibility is ruled out, it would not be possible for a system with accounts to 

exactly mimic benefi t levels payable from any given defi ned-benefi t-only plan. But provided account 

administrative costs are kept very low, it would be possible for a Social Security system with accounts to 

pay the same benefi ts on average as does any given defi ned-benefi t-only plan.10

If the accounts were determined to be government owned and if they were invested in federal government debt, they would be treated very much like the current trust fund. Account contributions would be 

treated as an outlay of the general fund and an offsetting receipt by the accounts, while the accounts’ investments in federal securities would not be recorded as an outlay. Hence, there would be no effect on 

the unifi ed defi cit, and any pre-funding for Social Security would continue to mask the size of the nonSocial Security defi cit. In that case, the accounts would offer only one advantage: The governmentowned account balances would be exactly offset by an easily identifi able offsetting obligation (benefi ts 

payable from the account balances). This would be analogous to specifying the current $2 trillion trust 

fund balance as the fi nancing source for some portion of defi ned benefi ts going forward. It is not clear 

that this would have a material effect on the conduct of fi scal policy.

If the accounts were determined to be government owned and if they were invested in private assets, 

then they would be accounted for like the current trust fund would be if it were invested in private assets. 

In both cases, the purchase of private-sector assets by a government account would be recorded as 

an outlay, so the unifi ed defi cit and publicly held debt would both increase.11 Compared to investing 

the trust fund in private-sector assets (an option that is discussed below), introducing government-owned 

accounts that were invested in private assets would have one advantage—they would result in an easily 

identifi able obligation (benefi ts payable from the account balances) that exactly offsets the value of the 

government-owned account balances. This situation would be analogous to investing the trust fund in 

private-sector assets and specifying the trust fund balance to be the fi nancing source for some portion 

of defi ned benefi ts going forward. As before, the key question is whether this would lead to a material 

change in the conduct of fi scal policy.

9 In this case, any increase in account balances would result in a reduction in ordinary defi ned benefi ts that leaves account owners with no net gain and leaves the government with no net change in its fi scal position. Hence, it is reasonable to rule that the account is not really private property. 

10 An offset to defi ned benefi ts might depend on a hypothetical account balance at retirement computed using specifi c 

prospective assumptions about earned rates of return. While these offsets can be defi ned so that expected benefi t 

levels are unchanged, actual benefi t levels would change depending on how actual rates of return compare with expected returns. Also, essentially similar benefi ts could be defi ned directly without explicit reference to account balances.

11 It is possible that current budgeting conventions might be modifi ed if government-owned accounts were to purchase 

private assets so that the asset purchases would not be recorded as outlays.
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SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

Other Possibilities for Administering Bare-Bones Accounts

Thus far, it has been assumed that the bare-bones accounts would be administered by a quasi-governmental entity. This would presumably allow some of the actual operations to be performed by private 

companies. For example, if accounts were invested in private assets, then the buying and selling of 

those assets would almost certainly be contracted out to a private company. Recordkeeping could also 

be contracted out, but that would probably be uneconomical given the amount of government oversight 

that would be necessary to assure privacy and accuracy. 

The bare-bones accounts could also be administered by a government agency, with the Social Security Administration being an obvious choice. In that case, cash fl ows to and from the accounts would 

be scored the same as in the case where the administrator is a quasi-governmental entity (or a private 

company, for that matter). The only potentially important difference is that policymakers might be more 

apt to view the assets held by the administrator as being available to help fi nance non-Social Security 

programs if the administrator were not viewed as being separate from the government.

It is possible that the Social Security Administration could administer a system of accounts at lower cost 

than could a new quasi-governmental entity. However, it would seem that any such cost advantage 

would be slight. The only synergies between the Social Security Administration’s current functions and 

account administration would concern data collection and recordkeeping, and data sharing between 

the Social Security Administration and a separate account administrator would be inexpensive if properly automated. 

STRATEGY 3: INVEST THE TRUST FUND IN PRIVATE-SECTOR ASSETS

A less-aggressive strategy to help safeguard Social Security surpluses would be to invest all or part of 

the trust fund in private-sector assets. As with personal account balances scored as privately owned 

investments, every dollar invested in such assets would most likely increase offi cial measures of outlays 

and the unifi ed defi cit by a dollar.12 But in this case, the assets purchased would be the property of 

the government rather than of individuals, and there would be no easily identifi ed offsetting government 

obligation. There is a risk, therefore, that any defi cits that would have to be run to purchase private assets for the trust fund would be netted against the value of the assets purchased, which would in effect 

result in policy choices being made with an eye toward the implications for the unifi ed defi cit less the 

trust fund’s investments in private assets (and publicly held debt less the value of private assets held in 

the trust fund). In that case, non-Social Security taxes and spending would be the same as they would 

be absent the purchase of private-sector assets by the trust fund, and the strategy would therefore fail to 

effectively safeguard Social Security surpluses.

What distinguishes privately owned accounts from trust fund purchases of private-sector assets is the implication each proposal would carry for the time path of government fi nancial net worth. Privately owned 

accounts increase publicly held debt, thereby reducing the time profi le of government fi nancial net worth 

and widening the unifi ed defi cit. Investing the trust fund in private-sector assets increases the government’s 

fi nancial assets and its fi nancial liabilities by the same amount, and hence has no effect on its fi nancial 

net worth. If budgeting decisions are made with reference to the government’s fi nancial net worth rather 

than to publicly held debt, then investing the trust fund in private-sector assets would not increase the 

chances that Social Security pre-funding is truly put aside to help pay future Social Security benefi ts.

12 The Congressional Budget Offi ce (CBO) made this determination in scoring President Clinton’s fi scal year 2000 

budget.
SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

16

U.S. DEPARTMENT OF THE TREASURY

Some analysts have advocated investing the trust fund in private-sector assets as a means of increasing 

trust fund rates of return rather than as means of safeguarding Social Security surpluses. However, as in 

the case of personal accounts, this is a poor rationale: The higher expected rates of return on risky assets merely compensate for risk that would ultimately be borne by taxpayers. And risky trust fund investments would not increase national saving, so risky assets held in the trust fund would just displace risky 

assets held in the consolidated portfolio of the private sector (the private sector would hold fewer risky 

assets and more federal debt). To the extent that risky assets held by the trust fund would earn higher returns, therefore, the resulting gain to taxpayers would be offset by lower returns earned on private-sector 

assets. Moreover, budget politics are such that it is likely that the taxpayers who would gain if trust fund 

equity returns were high would not be the same taxpayers who would lose if trust fund returns were low. 

This would occur, for example, if the policy response to movements in equity prices involved passing 

through higher equity returns to benefi ts relatively quickly, but delayed reducing benefi ts in the face of 

lower returns until Social Security’s fi nances were in crisis. In that case, current generations would enjoy 

the upside risk while future generations would bear the downside risk.

Trust fund equity investments might also reduce the perceived urgency for Social Security reform, thereby 

delaying reform and causing Social Security to be less fair to future generations. This would occur if the 

Social Security trustees were to decide to project Social Security’s fi nances under the assumption that 

trust fund equity holdings are certain to receive the expected return on equities rather than the proper 

risk-adjusted return, which is the return received on risk-free assets. In that case, trust fund equity investments would only result in an illusory improvement in Social Security’s projected fi nances.

Finally, there is one additional important downside to investing the trust fund in private-sector assets: 

Political considerations might infl uence investment choices and how equity shares are used to infl uence 

questions of corporate governance. 

STRATEGY 4: INVEST THE TRUST FUND IN MARKETABLE FEDERAL DEBT

If the trust fund were invested in marketable federal debt rather than in special-issue government securities, 

there would be essentially no change in the way the trust fund is accounted for in budgetary calculations. 

Current budget accounting norms dictate that the purchase of federal debt is not scored as an outlay; 

in addition, any publicly held debt purchased by the trust fund becomes public debt held by a federal 

government account (as are the current special-issue government securities held by the Trust Fund), thereby 

ceasing to be publicly held debt. Hence, the time path for the unifi ed defi cit, publicly held debt, and 

government fi nancial net worth would not be affected by this policy. There would therefore appear to be 

no reason for the government’s fi scal situation to be perceived any differently in this case.

CONCLUSION

Making Social Security fair to future generations requires reforms that involve substantial true pre-funding 

of future Social Security benefi ts. Attempting such pre-funding through the trust fund runs a signifi cant 

risk that it would be offset by higher non-Social Security defi cits, in which case a Social Security policy 

that is more fair to future generations will be offset by a non-Social Security fi scal policy that is less fair. 

Large dividends would be realized, therefore, if a mechanism could be found to increase the odds that 

attempted Social Security pre-funding would represent true pre-funding.
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SOCIAL SECURITY REFORM: MECHANISMS FOR ACHIEVING TRUE PRE-FUNDING • ISSUE BRIEF NO. 4

Nearly all analysts agree that personal account assets owned by participants would constitute true prefunding. Moreover, if account investments were conservative and pooled (i.e., if no investment choices 

were permitted), then accounts would be relatively inexpensive to administer and would have very little 

effect on the level and certainty of total Social Security benefi ts. In that case, accounts would offer the 

benefi t of increased confi dence that Social Security pre-funding is true pre-funding. Making policymakers and voters aware of these facts will require some effort, as some mistakenly believe that the principal

benefi t of accounts is to permit access to equities’ higher expected returns.

Investing the trust fund in private assets might increase the odds that trust fund accumulations would 

constitute true pre-funding. Such a policy would increase publicly held debt and offi cial measures of the 

unifi ed defi cit, but it would be easy to see that the increased publicly held debt is offset by the value of 

private assets owned by the government. It is quite possible that policymakers would be unconcerned 

by any defi cits that result from purchasing private assets for the trust fund, and would therefore make 

policy choices based on their implications for the unifi ed defi cit less trust fund investments in private assets and publicly held debt less the value of private assets held in the trust fund. In that case, non-Social 

Security taxes and spending would be the same as they would be absent the purchase of private-sector assets by the trust fund, and the strategy would therefore fail to effectively safeguard Social Security 

surpluses. Moreover, there is a substantial risk that trust fund equity investments would be improperly 

scored as reducing Social Security’s actuarial imbalance, and that political considerations would infl uence investment choices and how equity shares are used to infl uence questions of corporate governance. And, as with personal accounts, the prospect of earning high returns on private assets is largely 

irrelevant to the pros and cons of investing the trust fund in private assets. 

Finally, investing the trust fund in marketable federal debt rather than in special-issue government securities is least likely to affect policymaker perceptions of the state of fi scal policy. The offi cial measure of 

the unifi ed defi cit would not be affected, and once the marketable debt is purchased by the government 

it would be offi cially scored as public debt held by a government account, the same designation currently given to special-issue government securities held by the trust fund.