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How Do Individual Social Security Accounts Stack Up?
EBRI Issue Brief #195
Paperback, 32 pp.
PDF, 191 kb
Employee Benefit Research Institute, 1998
As the Social Security debate heats up, the unprecedented quantitative analysis available through SSASIM will provide policymakers and the public with information necessary for making informed policy decisions. In fact, this type of model was specifically suggested for use in the recommendations regarding research and data in the Report of the 1994-96 Social Security Advisory Council (Social Security Advisory Council, 1997).
This report shows cost, benefit, national saving, and growth projections under five options for reforming the Old-Age and Survivors Insurance (OASI) program. Of these, two are partially privatized ("two-tiered") options with individual account contributions equal to 5 percent of taxable payroll. One option is modeled under the assumption that, on average, participants invest individual Social Security account balances in a "life-cycle" mix of equities and Treasury bonds, while the other option is modeled assuming 100 percent Treasury bond investment. In addition to the two-tiered options, the report presents projections for three traditional reforms that would bring the current system into financial balance: the first would exclusively raise taxes; the second would raise taxes as well as the normal retirement age (NRA); and the third would reduce benefits only.
A man and woman of the 1976 birth cohort are modeled because they are part of a cohort whose members would pay transition costs over their entire working lives under the generic two-tiered options modeled in this report. (Transition costs are likely to be spread across a time period at least this long under actual reform proposals.) A man and woman of the 2026 birth cohort are modeled because they are scheduled to pay no transition costs. Thus, results are illustrative of a "worst case scenario" in terms of potential transition burdens for the 1976 cohort and a best case scenario for the 2026 cohort.
Results indicate that one traditional reform that would cut future Social Security costs is increasing the NRA to age 67 more quickly than under current law and indexing it to longevity thereafter. This reform would allow payroll taxes to be scheduled 9 percent lower after 2025 than those under a system that only increases taxes to fund current-law benefits. By 2070, cost rates under a reform that raises the normal retirement age like this would be 13.4 percent lower than those associated with funding benefit projections under the current system.
Two highly controversial assumptions have been made in order to model the nontraditional, two-tiered options in this EBRI Issue Brief. First, this analysis assumes that a system of individual accounts is administratively feasible. In addition, individual account balances are assumed to be preserved for retirement, contrary to the results of legislative activity of recent years that has expanded the potential for nonretirement use of savings in individual retirement accounts (IRAs) and employment-based pensions. If any individual account balances were available for preretirement withdrawals, the benefit projections reported for the two-tiered options in this report would be overestimates. Finally, individual Social Security account balances are assumed to be converted into indexed life annuities at retirement, allowing direct comparison of projected benefits under a partially privatized reform with those of the current system.
Like the reform that raises the NRA, both two-tiered options would reduce future Social Security costs, but not until the transition costs to a partially privatized system are paid. In the two-tiered reforms modeled here, these costs are projected to equal 5 percent of taxable payroll over 40 years. Until the transition costs are fully paid, the two-tiered options are projected to require 18 percent higher average tax/contribution rates than a reform that raises taxes to maintain the current system.
To reduce costs over 75 years relative to funding the current system, the traditional defined benefit portion of the Old-Age and Survivors Insurance (OASI) program would be scaled back 70 percent by 2040 under the assumptions used in this study. Largely as a result, annual real average benefits under a two-tiered system, even where a portion of account balances are assumed to be invested in equities, are lower for "average" women of the 1976 birth cohort and "average" men and women of the 2026 birth cohort relative to raising taxes only. Average women of both cohorts could expect to receive between 15 percent and 20 percent lower annual real average benefits under the Two-Tiered Option with Life-Cycle Investment than under a funded current system.
Average women of both cohorts, like the working poor, are projected to receive lower annual real benefits under both two-tiered options than under a funded current system in part because these groups tend to benefit most from the redistributive nature of the current Social Security program.
Largely because of transition costs paid from 2000-2040, payback ratios for persons born in 1976 are higher under a reform that funds the current system than under the Two-Tiered Option with Life-Cycle Investment. In contrast, because the 2026 cohort is projected to enter the work force after transition costs have been paid, this cohort is projected to receive significantly higher payback ratios under the Two-Tiered System with Life-Cycle Investment than under a financially balanced current system.
Although 2026 cohort members pay no transition costs to lower their payback ratios under the Two-Tiered, All Bond Investment option, they also would not get high enough returns on their investments to offset the attendant reduction in traditional OASI benefits. The implication is that while the two-tiered options do not provide higher payback ratios than Raising Taxes Only for the 1976 cohort because of the transition costs scheduled in this analysis, the prospect of higher payback ratios for the 2026 cohort, which pays no transition costs, exists only if the beneficiary invests to some extent in equities.
In terms of payback ratios and annual real benefits, the results obtained in this analysis indicate that women born in 1976 would be better off under a reform that raises taxes enough to bring the current system into balance or a system that also raises the NRA than under either of the two-tiered options. In terms of final average earnings projections, an average woman born in 1976 is projected to receive $2,042 more in preretirement earnings under the two-tiered approach that assumes life-cycle investment in equities. However, she is also likely to receive 10.4 percent less in average lifetime earnings plus net benefits under this option than under a reform that increases taxes enough to fund the current system.
The two-tiered options involve more market risk than the traditional Social Security reform. At the 95th percentiles, benefits under the Two-Tiered Option with Life-Cycle Investment could be much larger than benefits under the more traditional reforms. However, at the 5th percentiles, benefits under the Two-Tiered Option with Life-Cycle Investment could be nearly as low as those under a system that reduces benefits only to bring the program into balance. Results suggest that from a perspective of policymakers who are more risk averse, adjusted real annual average benefits under the Two-Tiered Option with Life-Cycle Investment are lower than those under more traditional reforms.
For some groups, such as the 2026 birth cohort, there may be a tradeoff between higher real average annual benefits under more traditional reforms and higher payback ratios under a two-tiered system, especially when benefits and payback ratios are adjusted for the higher levels of market risk inherent in a two-tiered system. Given the assumptions used in this study, risk-adjusted annual benefits are definitively higher under more traditional reforms such as Raising Taxes Only or Raising Taxes and the NRA, while risk-adjusted payback ratios are generally larger under a two-tiered system for the 2026 cohort even at higher levels of risk aversion.
National saving is projected to be approximately 4 percentage points higher by 2040 under the Two-Tiered Option with Life-Cycle Investment than under the more traditional reforms. One explanation is the partially prefunded nature of the two-tiered system. Plus, the additional contributions made to this system through transition taxes also increase national saving, as does the assumption that a portion of prefunded benefits will be invested in equities through life-cycle investing patterns. Theoretically, however, a defined benefit system could also be designed with taxes and policy parameters that would achieve the same level of national saving.
As a result of an increase in saving under the two-tiered system modeled in this report, real per capita gross domestic product is projected to be $3,600 higher by 2070 than under more traditional reforms. In addition, men born in 1976 are projected to receive about $3,950 more in preretirement earnings under a two-tiered system than under the more traditional reforms, and their female counterparts are projected to receive about $2,000 more.
Under the Two-Tiered Option with Life-Cycle Investment, an average man born in 1976 is projected to receive 7.8 percentage points less in average earnings plus net benefits, and his female counterpart is projected to receive 10.4 percentage points less. However, for the 2026 cohort, highest lifetime average earnings plus net benefits is projected under the Two-Tiered Option with Life-Cycle Investment. The average man of this cohort is projected to receive 1.3 percentage points more in average earnings plus net benefits under the Two-Tiered Option with Life-Cycle Investment than under Raising Taxes Only, whereas the average woman born in 2026 is projected to receive 1.6 percentage points less.
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