Social Security is the largest source of retirement income for most American workers and their families. Since the program began paying benefits in 1940, Social Security has served as a publicly provided source of retirement income for workers. The program also provides benefits for dependents, survivors, and the disabled and covers about 96 percent of all workers. Social Security’s benefit structure is based on a formula that replaces specified percentages of lifetime average indexed earnings. The basic benefit formula is redistributive in that the percentage of lifetime earnings replaced (replacement rate) is higher for lower earners than it is for higher earners. Benefits for dependents and survivors are generally based on the earnings record of the worker from whom benefits are claimed. When Social Security was instituted, the age of eligibility for full benefits, or normal retirement age, was set at age 65. The Congress later enacted an early retirement age of 62 at which any worker could retire with actuarially reduced benefits. The normal retirement age is set to rise according to a phased-in schedule to age 67 by the year 2027. Social Security is financed mainly through payroll taxes paid by workers and employers on covered earnings up to a maximum annual earnings level.The program is generally financed on a “pay-as-you-go” basis with the payroll taxes of current workers used to pay the benefits of current beneficiaries. Periodic surpluses of revenues over expenditures are credited to the Social Security Trust Funds, which represent future financial commitments by the government to the program. Current Trust Fund projections show that projected future revenues, including the amounts credited to the Trust Funds, will not be sufficient to finance full benefits in the year 2037 and thereafter. The Congress has addressed Social Security’s solvency in previous reform efforts, notably the 1977 and 1983 Amendments to the Social Security Act. These reforms focused on modifying the program’s existing benefit and financing structures without introducing major changes in the program. The reforms tended to focus on traditional options such as increasing the payroll tax rate or covered earnings, altering the benefit formula, and increasing the age of retirement. For example, the 1977 Amendments made technical changes to the benefit formula, lowered benefits, and set higher future payroll tax rates. The 1983 Amendments made a number of changes, including advancing the payroll tax rate increases enacted in 1977, increasing the number of workers covered under Social Security, and enacting a gradual rise in the normal retirement age to 67, which began to be effective this year. Despite the importance of these earlier reforms, there is relatively little evidence regarding their effects that is directly applicable to understanding the implications of current reform efforts on private pensions. Part of the reason for the lack of evidence is that the effects of Social Security reforms on pensions are intertwined with broader economic trends and coincident changes in tax and regulatory policies. The nature of the current reform debate changed when the 1994-1996 Social Security Advisory Council discussed a broader range of reforms.In addition to debating traditional reform options, the Advisory Council considered changing the basis for financing the program to include private investment. One option would involve government investment of Trust Fund assets in marketable financial securities. Another option would create an account for each worker, who could then invest in marketable securities. While both of these options might reduce the future cost of Social Security to employers and workers, the individual account option would have greater potential implications for Social Security’s benefit structure. This report will focus on individual accounts rather than collective investment because of the implications for the benefit structure and because numerous proposals incorporating individual accounts with more traditional options have been put forth to address the program’s long- term solvency. Before the creation of Social Security, private pensions played a modest role in providing retirement income. However, from 1940 to 1970, the percentage of private wage and salary workers participating in private pension plans increased from 15 to 45 percent due to a variety of factors, including changes in tax and labor policies. This growth in pension participation has slowed, however, and has stabilized since 1970 at about one-half of the workforce.Historically, the pension system developed with defined benefit pension plans as the predominant form of coverage. Defined benefit plans generally provide benefits using a specific formula based on the earnings and tenure of the worker. Typically, defined benefit plans are funded completely by the employer, who bears the investment risk of such an arrangement. The other major type of pension plan is the defined contribution plan, which generally involves contributions by the employer to an individual account held for the worker, with the worker bearing the investment risk. Some defined contribution plans are structured to allow contributions by the employee. Often, defined contribution plans are provided by employers as a supplement to defined benefit plans. The current framework of the private pension system was shaped largely by the Employee Retirement Income Security Act (ERISA) of 1974. ERISA imposed specific requirements for vesting after which participants are entitled to benefits that is, the years of service requirements to protect pension promises and workers’ benefits. It established guidelines for the operation and funding of pension plans. ERISA also required plan termination insurance to protect workers’ benefits under private sector defined benefit pension plans. In part to encourage plan sponsorship, pension plans have long been accorded favorable income tax treatment under the tax code. Employer contributions to pension funds, up to certain limits, are deductible expenses, and employee contributions and the contributions’ investment earnings are deferred from taxation. The 1980s saw the institution of certain employee deferral defined contribution arrangements under section 401(k) of the Tax Code, which generally allow tax-deferred worker contributions in addition to employer contributions.The growth of 401(k) plans has been cited by experts as a major factor underlying the recent trend toward the greater availability of defined contribution plans, in addition to other factors, such as the increased costs of defined benefit plans partly associated with increased regulation and changes in income tax laws, which reduced the tax advantages of pensions. Social Security provides about 38 percent of the aggregate cash income of the elderly (see fig. 1). Private pensions are a voluntary, employer-provided source of retirement income that comprises about 10 percent of aggregate elderly income.Also, some pensions are provided by public employers such as federal, state, and local governments. These comprise about 8 percent of aggregate elderly income. Pensions generally supplement Social Security benefits. For all but the lowest and highest income quintiles, pensions are the second most important source of retirement income (see fig. 2). In contrast, the benefits provided by Social Security are most important to workers and households in the middle ranges of the income distribution. Social Security comprises over 80 percent of the retirement income for households in the first (lowest) and second quintiles of the distribution. For the third (middle) and fourth quintiles, Social Security still serves as the most important source of retirement income. For the highest quintile, pensions are a more significant source of retirement income than is Social Security (20.5 percent compared with 18.3 percent), but pensions represent a smaller share for this group than either personal savings or earnings. One factor underlying these data is that pensions are not a universal source of retirement income as is Social Security. As of 1999, about half of the working population was covered by a pension. Although a larger number of workers may obtain some pension coverage over an entire career,it is unlikely that pension coverage will ever match the nearly universal coverage provided by Social Security. Social Security and private pensions are key sources of retirement income that are linked through the employer costs associated with the compensation provided to workers. Employers consider Social Security provisions in designing pensions that complement their human resource and other business strategies. Some of the interactions between Social Security and pensions are explicit, insofar as pension laws and regulations permit employers to formally “integrate” or take account of Social Security benefits and contributions in designing their pension plans. In addition, many pension plans may be indirectly or implicitly linked with other Social Security features, such as the normal retirement age or eligibility criteria for disability benefits. Many employers choose to offer a pension plan to further their business strategies or objectives. Although employers are motivated to offer a pension plan for many reasons,the most important involve (1) the employer’s need to attract and retain a workforce in a competitive labor market and (2) the tax advantages, or preferences, associated with pensions. The employer’s pension plan decision also will be shaped by the nature and characteristics of the workforce available to the employer and the employer’s size and type of industry. These factors will enter into the decision about the type of plan the employer will choose to sponsor and the benefits it provides to individuals at different income levels. Employers typically want to attract workers based on their productivity, motivate them to perform efficiently in pursuit of the firm’s goals, and retain them to reduce the costs associated with turnover. Pensions provide a tool for accomplishing these objectives. For example, pensions are a means of providing deferred compensation that may encourage workers to make long-term commitments to employers. This may have the benefit of reducing turnover, making for a more stable, productive workforce.At the same time, employers also want to manage the retirement of their workforce, and pensions are a means of offering incentives for workers to retire immediately or sooner or later than they would otherwise. Employers also choose to sponsor pension plans because of the favorable federal tax treatment of pension contributions and asset returns. This favorable tax treatment lowers the cost of a dollar of pension compensation to workers relative to an additional dollar of cash earnings. Business owners and more highly paid employees find this tax treatment attractive. Also, the tax advantages of pensions have traditionally played a role in the financial management of the corporation, allowing firms some flexibility in minimizing their tax liability and funding plans less expensively. For example, a firm may contribute, subject to certain conditions and limitations, more to the plan during profitable years, thus lowering its tax liability, and less during times when profitability is poor.