The Status Quo

Social Security is a pay-as-you-go system. Unlike a privately funded plan where contributions are invested in wealth-producing assets for retirement, Social Security taxes are immediately paid out as benefits. Should taxes exceed benefits, which has been the case in the U.S. since 1983, the surplus is not explicitly saved or invested for future payments.

Today's benefits to the old are paid by today's taxes from the young. Tomorrow's benefits to today's young are to be paid by tomorrow's taxes from tomorrow's young. Thus, benefit payments are an intergenerational transfer of wealth from younger workers to older retirees.

The total amount that can be paid in benefits is the payroll subject to tax times the tax rate applied to that payroll. Holding the tax rate constant, benefits can increase year-to-year by no more than payroll increases. In the United States, that increase over the last four decades has been about 1.6 percent per annum, adjusted for inflation and increases in the work force.

This is the rough equivalent of saving and investing for retirement and earning an annual real rate of return of 1.6 percent. Investing $1,000 at the end of each year for a 44-year working career at this average rate of return would accumulate to about $63,000.

Over the last three quarters of a century, a portfolio of stocks and bonds--with a 60/40 percent allocation, respectively--earned an annual average 5.5 percent real rate of return. At this rate, the yearly $1,000 saving would have accumulated to about $172,000. A portfolio of only stocks, earning 7.4 percent annually, would have grown to about $296,000. Neither capital market returns nor the accumulated wealth from investing in them were without risk, but this simple comparison is at least a first glimpse that compares pay-as-you-go to market-based financing.

The Role of Demographics
Keeping payroll taxes and benefits reasonable in a pay-as-you-go structure requires many workers to tax for each individual who receives benefits. This ratio is primarily determined by life expectancy and the fertility rate: the average number of births per woman during her childbearing years. If life expectancy increases or the fertility rate falls, the relative number of workers declines.

Life expectancy is influenced in part by wealth. People who live in wealthy countries generally experience longer lives than people who live in poor countries. Thinking about it, it makes sense. Wealthy countries can more easily afford clean water, clean air, better medical facilities and access to them, the benefits of advanced pharmacology, and the like: the things that make it easier for all of us to survive. In the World Bank's path-breaking book, Averting the Old Age Crisis, the authors state:

The proportion of the population that is old rises with per capita income. In low-income countries, less than 7 percent of the population is over 60. This proportion rises to 12 to 16 percent in middle-income countries to 17 percent or more in most high-income countries. The ratio of old people to working age people (the old age dependency ratio) also rises with per capita income--a relationship that stems directly from the lower fertility rate in richer countries and the ability to lengthen life span through medical intervention.¹

The fertility rate that ultimately stabilizes the size of a population is called ZPG or zero population growth. It is 2.1. That is, if women had 2.1 children, the population eventually would neither grow nor shrink. As stated above, poor countries have higher fertility rates than wealthy countries.

In sharp contrast, consider data from the Central Intelligence Agency's The World Factbook 2001.² Wealthy (GDP per capita) Switzerland ($28,600) has a fertility rate of only 1.47, whereas poor Mozambique ($1,000) has a fertility rate of 4.82. Most of the world's countries lie roughly between Switzerland and Mozambique in both metrics of wealth and fertility rates.

Interestingly, however, abnormally low fertility rates prevail throughout much of wealthy Europe and Japan. For example, note: Germany, 1.38; France, 1.75; Italy, 1.18; Spain, 1.15; Japan, 1.41, while the range of GDP per capita for these countries is $18,000 to $24,900.³ As has been pointed out by others, "there is now no single country in Europe where people are having enough children to replace themselves when they die." While these low fertility rates challenge the very survival of Europe's Social Security systems, public pensions account for as much as 80 percent of total retiree income.⁴ Over time and without change, Europe's elderly will face increasing insecurity.

An interesting paradox is that as countries become more wealthy, their pay-as-you-go pension systems become more frail because of the relationship between wealth, fertility rates, and life expectancy. As time passes, low fertility rates and increased life expectancy cause the number of working-age people to fall relative to those over 65 years of age. According to a study by the Center for Strategic and International Studies, there will be a marked decline in this ratio for many of the world's richest countries.⁵

Forecasts of the Number of Working-Age People
for Each Person Over Age 65

The Search for New Solutions

One of the often-proffered suggestions is reducing benefits. Such reductions are usually expressed in rather opaque terms such as raising the eligible age to receive benefits, increasing the years of wage income necessary to receive full benefits, establishing initial benefits to price instead of wage indexing, adding or changing bend points in benefit formulae, pegging benefits to life expectancy instead of a specific retirement age, and so on.

Reducing benefits, if applied in isolation, is the flip side of raising taxes. It approaches the financial challenge in strictly cash flow terms. From this narrow perspective, raising taxes or reducing benefits makes sense. But neither appropriately addresses broader long-run societal, financial, or economic concerns, and neither changes below-replacement birth rates or the increasing of life expectancy. Reducing benefits, much like raising taxes, is a financial patch.

Another solution, which has only recently gained ground, is the fundamental restructuring of pay-as-you-go systems to market-based financing. That is, paying less in Social Security taxes and investing that amount in wealth-producing assets such as stocks and bonds.

Strictly moving to market-based financing, however, is not a panacea. Market-based systems can be poorly designed, less efficient than pay-as-you-go systems, and riddled with risk, and can ultimately fail. It is important that their design take into account all the benefits of markets while not incurring the costs of a poor administrative structure.

Design Considerations
Countries that eventually employ market-based financing probably will adopt some common design characteristics, although no two countries will likely settle on exactly the same administrative structure. One reason is national pride; another is that their starting points differ. For instance, the development of capital markets is well-established in some countries and nascent in others. This effects the decision on whether portfolios may invest across borders or not. This in turn influences investment risk.

Computer technology, availability of hardware, and software applications are not uniform across countries. This will influence the timing of investment flows, portfolio pricing, the ability to change asset classes in an individual's portfolio, and whether individual portfolios are even a possibility.

Personal property rights are well-established in some countries and not in others. In the latter case, this may require that the government owns the assets and, therefore, makes all investment and benefit decisions. From an administrative point of view, this is a more simple design than that required for individual accounts.

The U.S. Case
In most countries, the above administrative issues have not been fully explored. The United States, however, is an exception. During the past seven or so years that Social Security reform has been debated here, an administrative platform has been designed. It was presented in testimony before the House Budget Committee Social Security Task Force in April 1999.⁸ Subsequent to the testimony, the committee's chairman, Congressman Nick Smith (R-MI), wrote a letter to David Walker, Comptroller General of the United States, in which he stated:

The House Budget Committee Task Force on Social Security recently heard testimony from William Shipman.... His firm completed a study that concluded that the administrative annual costs for establishing broadly diversified Social Security personal retirement accounts would equal between $3.38 and $6.58 per account holder. If verified, I believe the conclusion will prove highly significant as Congress evaluates plans to modernize the retirement system. It will demonstrate that it is possible to provide meaningful investment opportunities to all Americans for only 1 or 2 cents a day. For that reason, I am requesting that the [U.S. General Accounting Office] study the methods and conclusion of this report to determine its accuracy.

The GAO report⁹ was published during June 1999. The administrative plan was also reviewed by the President's Commission to Strengthen Social Security and in large part adopted by the commission in its December 11, 2001, report.

This design, arguably the most thorough to date, was conceived by a working group of academics, investment and recordkeeping professionals, actuaries, and individuals involved in both policy and politics. Almost all in the group had been involved in Social Security issues for years, in some cases as long as 20 years. This was particularly helpful because the group was able to consider not only narrow technical points, but broader political and policy considerations as well.

The goal was to design a platform for an individual-account, market-based Social Security option. It considered eight necessary components:

1. Create individual accounts with assets owned by the account holder.
2. Ensure reasonable costs for all participants, low- as well as high-income workers.
3. Minimize employers' administrative burden.
4. Provide the opportunity for workers of all incomes to invest in capital markets.
5. Ensure that inexperienced investors will not suffer poor returns relative to experienced investors.
6. Provide investment choice.
7. Offer a solution for workers who make no investment choice.
8. Automatically adapt to changing technology and services offered by the financial services industry.

These objectives were considered important because they had been central in the U.S. debate on Social Security reform. They are also integral to the most popular defined contribution system in the United States, the 401(k) plan.¹⁰ Indeed, the 401(k) plan structure is often referenced as a potential model for an individual retirement account Social Security plan.

The 401(k) Plan: History and Structure
Since the late 1970s, defined contribution systems have increased in popularity among American companies and workers. And just since 1985, those that have sponsored as well as those that have participated in 401(k) plans have increased several fold.

Under 401(k) programs, a plan sponsor, usually a company or union, oversees administration of a savings and investment program for its employees. Under such plans:

• Employees opting to participate in the program designate the amount they wish deducted from their pay.
• Employees select investment options prescribed by the plan sponsor.
• The plan sponsor deducts the specified funds from the employee's pay and in many cases invests the funds as of that day in the designated investment vehicles.
• Deductions are made on a pre-tax basis.
• Investment earnings grow on a tax-deferred basis.
• Benefits are subject to tax when taken out.
• In many plans, the employer provides some level of matching contribution to the employee's account.
• Account holders normally can call an 800 number voice response unit or individual account representative and change their portfolio holdings and receive that day's closing price for each asset traded.

In the early years of 401(k) plans, investment options were often limited to a stable value fund, a diversified fund, and company stock. In recent years, however, there has been a significant increase in investment choice. Many plans now include a large number of investment options as well as self-directed brokerage accounts. These accounts provide access to a large universe of institutional and mutual funds as well as individual securities. With all of the choice available, individuals can now create portfolios that are appropriate for their age, their risk tolerance, and their wealth objectives.

The "Social Security/401(k) Plan" Challenge
The major challenge in creating a 401(k) model of individual accounts linked to Social Security is the timely posting of individuals' savings contributions. This is not possible given the present Social Security recordkeeping system.¹¹ Although the Treasury Department has built a comprehensive system for the collection of FICA taxes from employers, there is no detailed record of individual taxes paid at the time they are collected and sent to Treasury. This information is not communicated to the government until the following year.

Companies remit FICA taxes in lump sums throughout the calendar year but do not forward to the government at the same time the names of the individual employees who paid those taxes or the amount each paid. That information is not provided to the government until the next calendar year when the employer sends W-2 forms to both the government and the employee.

Treasury knows throughout the current year, for instance, that a company has paid a sum of FICA taxes for its employees, but the Social Security Administration will not update its records until June or so of the following year, and possibly a few months later, with the names of the individual workers who paid those taxes and how much each worker paid. The government never knows when during the year the individual paid the taxes.

This recordkeeping process, although workable in Social Security's defined benefit structure, is unworkable in a daily-environment defined contribution structure. But it is all that currently exists for identifying individual payroll taxes.

The Solution: A Three-Level Approach

A solution to this recordkeeping problem is to structure investment options, not all of which require timely and detailed contribution data. This approach involves three investment levels.

Level One Investment: A Pooled Money Market Account
At the first level, workers' savings are deducted from payroll and invested in a collective money market fund. Workers own the assets of the fund, although the accounting at the individual level is not completed until the following year. This reconciliation is accomplished with the filing of the W-2 form. When the individual's assets are accounted for, units in the money market fund, which include earned interest, are then posted to each worker's account. The fund is dollar priced, which means each unit is always valued at one dollar.

The units are then invested in one of three balanced funds selected by the worker. Individuals who do not or choose not to make a selection have their assets invested in a default option, which is one of the balanced funds. The account holder has the option--after a startup of about three years, a period required to successfully build up assets to achieve economies of scale--to transfer some or all of his balance to an appropriate retail retirement account.

This pooled account would be a conservative fund similar to a large institutional money market fund. The funds would be held in this pool earning interest for all participants.

Given that the timing of an individual's contribution is not known, all participants are assumed to invest on June 30. The effect of this recordkeeping accommodation is that interest credited to one's account could be more or less than what was actually earned. In most cases, the differences are trivial. For an average-income individual who works continuously throughout the year, there is no effect. High-income workers, however, would effectively subsidize other workers because high-income workers would contribute a disproportionate amount of their income during the early part of the year. Alternatively, individuals who enter the labor force after mid-year would benefit from this accommodation.

Each worker would know during the year how much is invested because it is the same as the year-to-date reduction in the FICA tax that goes to savings, often referred to as the carve-out. The carve-out may be itemized as a separate line item on the pay stub. Interest would always accrue, so the account balance would be in excess of the contribution. All workers, regardless of income, would receive an identical rate of return. Funds would remain in the money market account until the reconciliation date of how much each worker contributed--about August of the following year.

Level Two Investment: Balanced Funds
When the individual account balance is determined, it is invested in one of three balanced funds that the worker chooses. Balanced funds are diversified portfolios that are generally invested in stocks, bonds, and cash.

The combined assets underlying very successful private, employer-sponsored defined benefit plans are essentially balanced funds. One of the Level Two balanced funds may have an allocation that closely approximates these plans. This allows all workers, if they wish, to maintain an asset allocation similar to that provided to the employees of many sophisticated corporations in the world. This would be the default fund. There would be another fund on each side of this fund: one for younger workers that would be weighted more toward equities, while the other would be weighted more toward bonds for those closer to retirement. Irrespective of their age, however, workers could choose any of the three funds.

Although workers could choose their balanced fund, some may not. In this case, they would default to the middle fund. In other words, a worker--perhaps low-income and financially unsophisticated--would be invested in a highly diversified balanced portfolio suited for retirement savings. The portfolios would be managed by professional asset managers chosen through an open and competitive bidding process.

Index fund investment management fees most likely would be less than two basis points: two one-hundredths of one percentage point. The balanced funds would be valued daily, and prices would be published in the popular press. Workers only need multiply their units, which are a constant for one year, by the daily price to monitor their account balance.

Level Three Investment: Rollover Option
After a period of perhaps three years--a period required to successfully build up the assets in the Level Two account system to realize economies of scale--investors seeking more investment choice would have the option of rolling their investment funds out of the Level Two asset allocation funds and into any qualified retirement investment account.

Those choosing Level Three would transfer assets to a qualified account with a financial services company meeting reasonable and specified standards.¹² While investors would have a wider range of choice within Level Three, there still would be reasonable investment guidelines. In Level Three, investment managers would act as the fiduciary for their product offerings and be subject to Department of Labor oversight. This is consistent with many employer-sponsored plans, both defined contribution and defined benefit.¹³

Level Three might well suit those workers who have a high degree of confidence in a particular money manager, a particular firm, or a particular style of investing. It will also serve investors seeking a type of investment unavailable in the Level Two asset allocation funds. An investor, for example, may wish a greater concentration of equity investments than is available in the asset allocation funds.

Should a worker find a particular Level Three provider or product unsatisfactory, the worker could transfer to another provider within Level Three or move back to Level Two. This assures competition across the Level Three retail platform as well as competition between Level Two, an institutional platform, and Level Three. This competition within and between Levels will ensure the lowest cost and best service for the entire system.

Recordkeeping and Administration
The administration of an individual account system will require the development of a large-scale, customized recordkeeping system with the capability to produce a highly efficient service solution. The efficiency of the service application will be dependent upon the design and execution of the system. There is no existing application that meets all the requirements.

The requirements to support a national individual account system will be complex, large-scale, and capital-intensive. As noted above, this is a challenge of unprecedented scope. Nonetheless, the application itself is relatively straightforward.

Development time can be minimized to allow focus on sizing and scaling the network and building the necessary interfaces to the Social Security Administration. Unlike mutual fund or 401(k) recordkeeping systems, there will not be many unique product features or functions, thus significantly reducing complexity and cost. It is reasonable to assume a system could be developed in 12-18 months to support these requirements.

The greatest challenge in building a recordkeeping system to support the requirements of an individual account system is not the complexity of the application, but the need to support the high volume of participant inquiries, transactions, transfers, and report generation. To keep costs low, it is critical that most participants utilize voice and Internet technology to obtain information and transact business. The greater the percentage of calls that requires a customer service agent, the higher the administrative cost.

The volume of calls will be driven by the frequency of transactions and statements, as well as average account size and market volatility. Assuming 140 million accounts and the plan described, participant call volumes are projected to range from 175 million to 350 million annually. In addition, the system will issue 140 million statements, process fund transfers, and distributions. This approach assumes the funds are priced daily and accounts updated nightly.

Whether the recordkeeping is done by a government entity such as the Social Security Administration or outsourced to the private sector, this task will require the formation of a large service organization to support these requirements. The service firm would need call centers in multiple locations around the country and would need to hire between 3,000 and 7,000 employees. For the purpose of this analysis, it is assumed that the Social Security individual account system will incur volumes between 0.5 and 1.0 calls per participant per annum.

Another important factor in projecting costs is determining what percentage of the participant's call volume will be processed by voice response and Internet technology versus requiring the services of a call center representative. The cost to handle calls using the technology is a fraction of the cost to process through a representative. Therefore, to achieve an efficient solution, it is critical that high levels of automation are achieved. The analysis assumes 85 percent of the call volume will be handled through voice and Internet technology, comparable to the levels currently achieved in many large defined contribution plans.

Cost Model
Based on the plan design defined above, a cost model has been developed to project the administration costs under a range of assumptions. The unit cost factors are based on experience in the 401(k) business and have been adjusted in some cases to account for the scale of the individual account option.

The requirements of a national system of individual accounts are unique, and, therefore, extrapolations from 401(k) experience pose some risks. Unlike the 401(k) structure, it is assumed that in a timely fashion the Social Security Administration will provide the individual account recordkeeper an accurate, automated transmission of earnings histories that will be used to calculate annual contribution data.

These and any other expenses associated with reconciling W-2 records are to be borne by Social Security and are not included in this cost model. It is also assumed that Social Security, at its cost, will maintain accurate and up-to-date employee address files, as will be necessary anyway with the annual mailing of Social Security statements starting in 2000. One's investment account statement would be included in this mailing.

Another cost not included in this model is the expense associated with communicating this program to employees. The assumption is that the government would bear these expenses. Therefore, they expressly are not included in the asset-based fees reported below. There is precedent for this in that the government pays directly some of the communication expense of the Federal Thrift Plan.

Cost Summary
Based on the design criteria outlined and unit cost assumptions, it is projected that the first year's administrative expenses to support an individual account system will range from $473 million to $922 million. Assuming 140 million accounts, this translates to a cost per account range of $3.38 to $6.58 in the first year.

Although costs would be expected to increase annually, driven primarily by employee compensation and benefits, assets would increase more rapidly. Costs as a percent of assets, therefore, would fall. Steady-state asset-based costs are projected to range from 20 to 40 basis points.

These costs are competitive with other investment products. For example, the Federal Thrift Plan, which is often used as an example of an efficient retirement plan, had an expense ratio of 65 basis points in its second year. Another benchmark is a portfolio of individual mutual funds representing different asset classes and weighted to approximate a Level Two balanced fund. Such a portfolio is presently available for a total cost of about 40 basis points.¹⁴

Although many approaches to the administrative challenges inherent in an individual account system linked to Social Security may be expensive, not all need to be. Under reasonable assumptions, a well-thought-out plan that meets our nation's retirement needs is affordable.

A Change in the Climate of Opinion

The debate surrounding the future of Social Security systems around the world has attracted a wide range of views and opinions. Although in most cases final designs are far from certain, and perhaps far off, open dialogue is a necessary precursor to their enactment.

These discussions over many years have focused policymakers and government leaders on the problem, the significant challenge, the stark implications of doing nothing, and the substantial benefits from thoughtful and successful reform. The willingness of all interested parties to engage in this debate will help more Americans and leaders of other nations understand the importance of solving one of the world's most challenging issues.

William G. Shipman is Chairman of CarriageOaks Partners LLC, a Massachusetts-based consulting firm specializing in retirement finance. He spoke at the Inaugural Symposium on Financing Global Aging, sponsored by the Rosenberg Institute of Global Finance, Brandeis University, Graduate School of International Economics and Finance.