Social Security Reform: President Bush's Individual Account Proposal

CRS Report for Congress
Social Security Reform: President Bush’s 2005
Individual Account Proposal
Updated March 9, 2006
Laura Haltzel
Specialist in Social Security
Domestic Social Policy Division


Congressional Research Service ˜ The Library of Congress

Social Security Reform: President Bush’s 2005
Individual Account Proposal
Summary
The Old-Age, Survivors, and Disability Insurance (OASDI) program, commonly
referred to as Social Security, is facing a long-term financial deficit. In response to
this challenge, President Bush made Social Security reform the key focus of his 2005
domestic social policy agenda. On February 2, 2005, the President laid out
specifications for a system of voluntary individual accounts to be phased-in as part
of a reformed Social Security system. Administration officials concede that the
individual accounts themselves do not alleviate the solvency problem. The individual
account proposal would likely make the solvency problem worse over the next 75
years. The President stated that these accounts are just one piece of a comprehensive
Social Security reform package and that additional measures will be needed to
achieve long-term solvency.
Under the President’s 2005 individual account proposal, individuals born prior
to 1950 would have experienced no change in their Social Security benefits.
Individuals born in 1950 and later would have had the option to participate in Social
Security individual accounts (IAs). Workers who chose to participate in IAs would
not have been permitted to opt-out of the IA system. Workers would have been
allowed to divert up to 4% of their payroll taxes to IAs, subject to a dollar limit that
increased over time. But on average people would have had to earn at least 3.3% per
year after inflation to break even. This would have occurred because, in addition to
administrative costs, their traditional benefits would have been reduced or “offset”
by the amount of their contributions, plus 3% a year in interest. The proposal did not
include a “minimum benefit” guarantee to ensure that participants would receive a
total benefit at least equal to the poverty threshold.
Analyzing the President’s 2005 IA proposal using assumptions on investment
returns and administrative costs provided by the Social Security Administration, CRS
found that the total of the reduced Social Security benefit plus the annuity that would
have been available using the actual IA balance would have exceeded Social Security
current-law promised benefits if the account earned the 4.6% annual real rate of
return projected by the Social Security actuaries. However, if the account earned the
2.7% risk-adjusted annual real rate of return projected by the actuaries, workers
would have faced a slight reduction in overall Social Security income relative to
current law. Younger workers and those with higher lifetime earnings would have
benefitted the most from IAs. Younger workers would have been able to contribute
to their IA throughout their careers and would have had higher contributions as a
result of continued wage growth. Higher earners would have benefitted from being
able to accrue larger account balances as the dollar cap on contributions increased.
This report is based on the President’s 2005 IA proposal. The version portrayed
in his FY2007 budget submission is not significantly different from his 2005
proposal. The main substantive difference is that the average interest that a worker
would need to earn to break even would be reduced to 2.7% from 3%. Thus, if the
account earned the 2.7% risk-adjusted annual rate of return, the worker would
experience no reduction in overall Social Security income relative to current law.



Contents
In troduction ......................................................1
The President’s 2005 Social Security Individual Account Proposal...........2
Individual Account Contributions .................................2
Account Administration and Investment............................3
Offset to Social Security Defined Benefit Based on Hypothetical
Individual Account ........................................4
Individual Account Distributions..................................6
Analysis of the President’s 2005 IA Proposal............................8
Effect on Social Security Solvency................................9
Effect on the Unified Budget....................................11
Effect on Combined Social Security Income........................12
Limitations of This Analysis................................14
Analysis by Birth Cohort...................................16
Analysis by Earnings Level.................................19
Methodology ....................................................21
List of Figures
Figure 1. Effect of the President’s Individual Account Proposal on Projected
Social Security Surpluses (Billions of current dollars)................12
Figure 2. Percent Difference Between Current-Law Payable Social Security
Benefits and Total Social Security Income (Reduced Current-Law
Payable Social Security Benefits Plus the Individual Account Annuity)...15
Figure 3. Total Social Security Income for Scaled Average-Wage Worker,
by Birth Cohort..............................................17
Figure 4. Effect of the President’s IA Proposal on Combined Social
Security Income, by Earnings Level for Worker Age 21 Today.........19
List of Tables
Table 1. Mary’s Actual and “Shadow” Individual Accounts................5
Table 2. How Mary’s “Shadow” Account Offsets Her Social Security
Defined Benefit and How Her Actual Account Contributes to Her
Social Security Income in 2031...................................6
Table 3. Estimated Account Balances in Year of Retirement for Actual
and “Shadow” Account Under the President’s 2005 Social Security
Personal Account Proposal, by Type of Hypothetical Worker..........24
Table 4. Current-Law Promised Social Security Benefit, Estimated
“Shadow” Annuity Amount in Year of Retirement, and Reduced
Promised Social Security Benefit, by Type of Hypothetical Worker.....25



“Shadow” Annuity Amount in Year of Retirement, and Reduced Payable
Social Security Benefit, by Type of Hypothetical Worker..............26
Table 6. Combined Social Security Benefit For Expected and
Risk-Adjusted Account Balances Under President’s Individual
Account Proposal Compared to Current-Law Promised Benefit, by
Type of Hypothetical Worker...................................27
Table 7. Combined Social Security Benefit For Expected and
Risk-Adjusted Account Balances Under President’s Individual
Account Proposal Compared to Current-Law Payable Benefit, by
Type of Hypothetical Worker...................................28
Table 8. Poverty Thresholds in Year of Retirement, Reduced Social
Security Promised Benefit, Required Annuitization Levels, and
Remaining Individual Account Balance, by Type of Hypothetical
Worker .....................................................29
Table 9. Poverty Thresholds in Year of Retirement, Reduced Social
Security Payable Benefit, Required Annuitization Levels and
Remaining Individual Account Balance, by Type of Hypothetical
Worker .....................................................30



Social Security Reform: President Bush’s
2005 Individual Account Proposal
Introduction1
The Old-Age, Survivors, and Disability Insurance (OASDI) program, commonly
referred to as Social Security, is facing a long-term financial deficit. In 2041, the
Social Security Trust Funds will be depleted and tax revenues will be sufficient to
cover approximately 74% of benefits promised at that time.
Given this challenge, President Bush made Social Security reform the key focus
of his 2005 domestic social policy agenda. On February 2, 2005, the President
issued a document, “Strengthening Social Security for the 21st Century,” which laid
out the specifications for a system of voluntary individual accounts funded out of the
current payroll tax to be phased-in as part of a reformed Social Security system.
Administration officials concede that the individual accounts themselves do not
alleviate the solvency problem.2 These accounts would likely worsen the solvency
problem over the next 75 years. The intent of these accounts was (1) to offset at least
a portion of the anticipated benefit reductions or tax increases that will be necessary
to achieve solvency; (2) to make the Social Security system a better deal for younger
workers, who are most likely to be affected by these changes; and (3) to provide a
benefit that each worker would individually own that the government could not take
away. The President stated that these accounts are just one piece of a comprehensive
Social Security reform package and that additional measures will be needed to
achieve long-term solvency.3 The President later espoused the idea of “progressive
price indexing” as one option for achieving solvency by indexing future benefits of


1 The President’s FY2007 budget submission included an updated version of his individual
account proposal. This version, outlined in a Social Security Administration actuarial
memorandum dated Feb. 6, 2006, included three specific changes: (1) the proposal would
become effective in 2010 instead of 2009; (2) the initial contribution cap would be $1,100
instead of $1,000; and (3) the offset to the worker’s traditional benefit would be based on
the amount of their contributions, plus 2.7% in interest instead of 3%. Of these three
changes, only the reduction of the offset rate alters the conclusions presented in this report
based on analysis of the 2005 proposal. Under the 2005 proposal, if the account earned the
2.7% risk-adjusted annual real rate of return projected by the actuaries, workers would have
faced a slight reduction in overall Social Security income relative to current law. In the
January 2006 version of the IA proposal, if the account earned the 2.7% risk-adjusted annual
rate of return, the worker would experience no reduction in overall Social Security income
relative to current law. Please note that the numbers presented in the remainder of this
report have not been updated to reflect this change.
2 White House Background Press Briefing on Social Security, Feb. 2, 2005.
3 President George W. Bush, State of the Union Address, Feb. 2, 2005.

high-wage workers to inflation while wage indexing future benefits of low-wage
workers. However, no specific details of how this proposal would be implemented
were released. Thus, this report focuses solely on the individual account component
of the President’s 2005 Social Security reform proposal.4
The President’s 2005 Social Security Individual
Account Proposal
Individual Account Contributions
Under the President’s proposal, individuals born prior to 1950 would have
experienced no change in their Social Security benefits. Individuals born in 1950 and
later would have had the option to participate in Social Security individual accounts
(IAs). Workers born in years 1950 through 1965 could have first participated in
2009. Workers born in years 1966 through 1978 could have first participated in

2010. Workers born in years 1979 and later could have first participated in 2011.


Those who chose to participate would have been able to divert up to 4% of their
Social Security covered wages into an individual account.5 The actual maximum
dollar amount of contributions would have be gradually increased, such that low-
earners would be able to immediately contribute a full 4% of earnings to their IA,
while higher earners would initially have their contributions capped. In the first year
of account availability, 2009, the cap on contributions would have been $1,000.
According to the Social Security actuaries, this cap would increase by $100 each year
and then be increased by the growth in the national average wage.6 For example, in
2010, the contribution limit would be equal to $1,100 increased by the growth in
average wages between 2007 and 2008, or $1,145. The actuarial memorandum only
covers the years through 2015, and the contribution limit rises using this method each
year until then. Although it is not specified in the actuarial memorandum, the
February 2, document implies that this dollar contribution limit would continue to
rise after 2015, but that contributions would never exceed 4% of covered wages.
Individuals who do not choose to participate in the IA system would continue
to draw benefits from the traditional Social Security system; however, these benefits
are likely to be reduced to achieve long-term solvency. Individuals who choose to
participate in the IA system would not be permitted to discontinue their participation,
would be subject to benefit reductions based on their participation in the IA, and
would also be subject to benefit reductions to achieve long-term solvency.


4 For additional information on price indexing, please see CRS Report RL32900, “Indexing
Social Security Benefits: The Effects of Price and Wage Indexes.”
5 In 2005, Social Security covered wages are capped at $90,000. This cap is indexed
annually to increases in the national average wage.
6 Social Security Administration Memorandum to Charles P. Blahous, Special Assistant to
the President for Economic Policy, National Economic Council from Stephen C. Goss, Chief
Actuary, “Preliminary Estimated Financial Effects of a Proposal to Phase In Personal
Accounts — INFORMATION,” Feb. 3, 2005.

Account Administration and Investment
Individual account contributions would be collected and records maintained by
a central administrator. Private investment managers would be chosen through a
competitive bidding process to manage pooled account contributions. The central
administrator would be responsible for addressing participant questions and issuing
periodic account statements. The Social Security Administration’s actuaries estimate
that the ongoing administrative costs for a centralized system with limited choice of
fund investment would be roughly 0.3 percentage points (or 30 basis points).7
Individuals who opt-in to the IA system would choose from a few broad-based
investment funds: a government bond fund; an investment-grade corporate bond
index fund; a small-cap stock index fund; a large-cap stock index fund; and, an
international stock index fund.8 In addition, workers could choose a government
bond fund with a guaranteed rate of return above inflation. Workers could also select
a “life-cycle portfolio” that would automatically adjust the level of risk and return of
the investments by gradually reducing the portion of the portfolio invested in stocks
and increasing the proportion invested in bonds as the worker aged in an attempt to
avoid sudden losses closer to retirement. This portfolio would be the default choice
for workers reaching age 47, although the worker could opt-out if the worker and his
or her spouse signed a waiver stating that they are aware of the risks. Workers would
be able to adjust their allocations among these funds annually.
Life-cycle portfolios reduce the probability of a sudden loss of capital due to a
decline in equity values, but they do not eliminate this risk. Furthermore, with the
switch to heavier investment in bonds rather than stocks comes a reduced expected
rate of return in the account balance. The rate of return one earns closer to retirement
has a greater effect on the overall account balance than the rate of return earned at the
start of a working career because that interest rate is applied to every dollar held in
the account at that point in time, not just the account a few years into one’s career.
Shifting the asset allocation to favor bonds does reduce the down-side risk, but it also
limits the up-side gains.9


7 Some have argued that this assumption may understate the true administrative costs of such
a system. The actuaries did not provide an estimate of the costs associated with
annuitization.
8 An index fund is a fund composed of securities intended to replicate the movement of a
specific securities index (e.g., the Dow Jones, Standard & Poors 500, etc.). Index funds are
considered to be passive investments since the portfolio manager does not have to decide
among various securities for investment. Rather, the manager knows the securities that make
up the index and their relative importance to the overall index and seeks to match it.
Because the management of the investment is less active, the expenses and transaction costs
are low. The advantage of index funds is that, since most funds do not beat the index
anyway, the investor has a greater chance of at least matching industry averages. The
limitation of the index fund is that it must purchase all of the securities in the index even if
the market indicates that a particular security in the index is going to lose value. (Taken
from p. 501, “How the U.S. Securities Industry Works,” by Hal McIntyre).
9 Robert J. Shiller of Yale University recently conducted a computer simulation using
(continued...)

In the scenario described in the President’s proposal, the life-cycle portfolio
would specify an asset allocation shift based on a worker’s planned year of
retirement. Thus, all workers retiring in a given year have the same portfolio of
stocks and bonds. The primary appeal of these “targeted retirement date” life-cycle
portfolios is the minimal involvement required by the investor. Once the individual
joins the fund, the assets are on auto-pilot and the individual does not need to decide
when or how to adjust the portfolio. However, this ‘one size fits all’ approach may
not be ideal for those who have investments outside the Social Security IA system as
it could undermine the intended overall asset allocation for that worker’s age. For
example, a worker who already has a great deal invested in bonds in a 401(k) plan
may not want the automatic shift towards bonds specified by a life-cycle portfolio
because it could place too great a portion of his or her assets in fixed income
securities. This approach may also not be ideal for those with different tolerance for
risk. For example, the asset allocation specified for someone at age 35 might be 80%
in stock and 20% in bonds. However, some individuals may be risk averse and prefer
a portfolio with 70% stock and 30% bonds.
Offset to Social Security Defined Benefit
Based on Hypothetical Individual Account
If a worker chooses to participate in an IA, in exchange for the reduction in
contributions to the defined benefit Social Security system, he or she would accept
a future Social Security benefit reduction. The benefit reduction would apply to the
Social Security retirement, spousal or aged widow(er) benefit that would otherwise
be paid to him or her.10 This future benefit reduction is equal to the contributions
made to the worker’s individual account plus 3% per year in interest. For each actual
account that a worker contributes to and receives upon retirement, there is also a
hypothetical “shadow” account that exists only as an accounting mechanism. The
“shadow” account records all of the contributions made to the actual account and
grows them at a fixed annual real rate of return (the rate one would earn after
adjusting for inflation) of 3%, essentially equal to what the Social Security
Administration actuaries project these contributions would have earned had they
continued to be paid into the Social Security system and invested in Treasury bonds11
in the Trust Funds. Thus, the 3.0% offset is intended to reflect the portion of the
Social Security benefit the worker chooses to forgo and replace with individual


9 (...continued)
financial data going back to 1871. He found that people enrolled in life-cycle accounts
would have lost money 32% of the time under the President’s IA proposal because the rate
of return earned is less than the 3% real rate of return required to break even in the proposal.
For additional information please see Robert J. Shiller’s study, “The Life-Cycle Personal
Accounts Proposal for Social Security: An Evaluation,” Yale ICF Working Paper No. 05-06,
Apr. 2005, available at [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=703221].
10 According to the Social Security actuarial memorandum, disability benefits would not be
reduced.
11 Unlike the actual individual account, which is reduced on an annual basis by 0.3% of
assets and results in an “expected” net 4.6% annual rate of return or a “risk-adjusted” 2.7%
rate of return, the “shadow” account is not reduced for any administrative fees. See the
Methodology section for additional detail.

account proceeds by diverting a portion of his or her payroll tax away from the Social
Security system.
Table 1 provides an example of how this would work. In this example, Mary
works and contributes to her individual account for 10 years, between 2021 and 2031.
Each year, Mary contributes an amount equal to 4% of her Social Security covered
wages to her individual account. For example, she earns $15,000 in 2021 and
therefore contributes $600 to her IA, where it is assumed to grow at a 4.6% annual
real rate of return and results in an end of year account balance of $622. When she
makes her $600 contribution to her actual IA, the “shadow” IA reflects this same
contribution amount, but grows it at a fixed 3.0% annual real rate of return so that at
the end of the first year her “shadow” IA records a balance of $617. This same
process continues every year until she retires in 2031. At that point, her actual IA
balance is $15,648 and her “shadow” IA balance is $14,327. Upon retirement, the
account balance of this hypothetical “shadow account” is converted into a
hypothetical CPI-indexed monthly annuity.12 This hypothetical annuity would be
used to reduce, or offset, the Social Security defined benefit.
Table 1. Mary’s Actual and “Shadow” Individual Accounts
Actual AccountShadow Account
AnnualActualAccountShadowAccountBalanceBalance (fixed
YearWageContributionsContributions(assuming 4.6%3.0% real rate of
(nominal)(nominal)(nominal)real rate ofreturn)
ret urn)
2021 $15,000 $600 $600 $622 $617
2022 $17,500 $700 $700 $1,395 $1,374
2023 $20,000 $800 $800 $2,329 $2,278
2024 $22,500 $900 $900 $3,438 $3,338
2025 $25,000 $1,000 $1,000 $4,734 $4,564
2026 $27,500 $1,100 $1,100 $6,231 $5,964
2027 $30,000 $1,200 $1,200 $7,944 $7,550
2028 $32,500 $1,300 $1,300 $9,891 $9,332
2029 $35,000 $1,400 $1,400 $12,087 $11,321
2030 $37,500 $1,500 $1,500 $14,552 $13,531
Account balance in 2031$15,648$14,327
Source: Created by CRS.
Continuing the example above in Table 2, based on Mary’s 10-year work
history, Mary could expect to receive a Social Security defined benefit equal to about
$654 per month in 2031. Mary’s “shadow” account would produce a CPI-indexed
annuity of $82 per month. This “shadow” annuity is used to reduce, or offset, Mary’s


12 An annuity is an insurance instrument that provides a stream of periodic payments in
return for an up front payment called the “premium.” In this case, the premium would be
the individual’s account balance at retirement.

Social Security benefit, leaving her with a Social Security defined benefit of $572.
Assuming that Mary chooses to annuitize her entire actual IA balance, Mary’s actual
IA would produce a CPI-indexed annuity of $89 per month. The annuity from the
actual IA plus her reduced Social Security defined benefit would provide Mary a
combined Social Security income of $661.
Table 2. How Mary’s “Shadow” Account Offsets Her Social
Security Defined Benefit and How Her Actual Account
Contributes to Her Social Security Income in 2031
Marys current-law Social Security defined monthly benefit $654
Minus “shadow” account monthly annuity (based on fixed 3.0% annual- $82
real rate of return)
Equals remaining Social Security defined monthly benefit= $572
Plus actual account monthly annuity (assuming 4.6% annual real rate of+ $89
return)
Equals combined Social Security monthly income= $661
Source: Created by CRS.
Note: Example assumes current law provisions remain in place through 2031 and that Mary chooses
to annuitize her entire IA balance.
Individual Account Distributions
Workers would not be permitted to have access to their IA balances prior to
retirement. Upon retirement, the receipt of aged widow(er) benefits, or conversion
from disabled worker to retirement benefits, the IA accumulation would be available
to the beneficiary. Individuals may be required to purchase an annuity or take in
phased withdrawals a portion of the IA balance. The portion required to be
annuitized or taken in phased withdrawals would be equal to the dollar amount
needed to provide the worker with a total monthly benefit equal to at least 100% of
the federal poverty threshold when combined with the reduced Social Security
defined benefit. For example, looking back at Table 2, Mary’s reduced Social
Security defined benefit would be equal to $572 (in 2005 dollars). In 2031, the year
of Mary’s retirement, the monthly poverty level is projected to be equal to $766 (in
2005 dollars). Thus, Mary would be required to annuitize or take in phased
withdrawals whatever portion of her IA is needed to provide a monthly stream of
income equal to $194 ($766 - $572).
The annuity purchased or phased withdrawals taken would be required to be
CPI-indexed so that the annual amounts increase with inflation and, thus, retain
purchasing power. If after the purchase of this annuity or estimation of phased
withdrawals the worker still has a balance in his or her IA, the remainder may be
withdrawn as a lump-sum or left as an inheritance. There would be no “minimum



benefit” guarantee to ensure that participants would receive a total benefit at least
equal to the poverty threshold.13
Under the system of phased withdrawals, also referred to as programmed
withdrawals or “self-annuitization,” the worker’s account balance is divided in such
a way as to allow the worker to withdraw an equal amount each month (indexed to
inflation) until the retiree dies or until the IA funds are depleted. This amount is
calculated taking into account projected future inflation, interest rates and life
expectancy. It has not yet been specified who will take the role of calculating the size
of these withdrawals. The advantage of phased withdrawals as opposed to an annuity
is that a worker who does not expect to live to projected life expectancy could
withdraw whatever portion of their IA assets are needed to stay above poverty and,
upon death, the remaining balance would be available to pass along as an
inheritance.14
When a worker purchases a CPI-indexed annuity, risks of higher than expected
inflation, lower than expected interest rates, and of living longer than an individual’s
projected life expectancy are borne by the insurance company. When a worker opts
to take phased withdrawals, these risks are borne by the worker. Thus, if inflation
grows faster than originally expected, the amount of money that the worker must
withdraw to remain above poverty would increase, leading the worker to deplete his
or her IA assets faster than planned. Under phased withdrawals, the worker retains
the responsibility for investing the individual account assets in such a way as to
ensure a rate of return that would maintain an account balance sufficient to provide
the appropriate level of withdrawals until the expected date of death. If the worker
fails to invest in such a way as to ensure the rate of return needed to maintain an
account balance until they die, then the withdrawal amounts would eventually exceed
the balance remaining in the IA, leading the worker to have insufficient resources to
remain above poverty. Under a phased withdrawal system, the worker also faces the
risk that they will live beyond the date of life expectancy that was used to calculate
the phased withdrawal amounts. The date of life expectancy is, by definition, the
average remaining number of years prior to death. Thus, on average, about 50% of
those opting for phased withdrawals will die prior to running out of IA funds and
50% will live longer than expected and run out of IA funds. In this case, the worker
would have received larger withdrawal amounts than could be sustained with the IA
balance at retirement and the worker would risk running out of funds prior to death.
Phased withdrawals do not guarantee that those with IA balances projected to be
sufficient at retirement (when the monthly phased withdrawal amount is calculated)
will avoid falling into poverty.


13 The plan does not specify whether the poverty threshold to be used is for the single
worker, for all individuals who are expected to receive benefits off of the worker’s record,
or all household members.
14 Not all individual accounts are likely to have large enough balances to provide a monthly
withdrawal amount that, when combined with the reduced Social Security defined benefit,
is able to provide a combined Social Security income equal to 100% of the federal poverty
threshold, whether provided in the form of an annuity or as a phased withdrawal. The
current-law Social Security program also does not guarantee a benefit amount equal to 100%
of the federal poverty threshold.

If a worker decides not to use inflation-indexed phased withdrawals of a portion
of his or her IA to maintain above poverty level retirement income, he or she would
be required to purchase a CPI-indexed annuity to achieve this goal. Although the
President’s plan requires the purchase of CPI-indexed annuities, there is currently a
very limited market for these annuities in the United States. Although the Treasury
has issued Treasury Inflation Protection Securities (TIPS) since 1997, the demand for
inflation-indexed annuities remains small, possibly because many workers feel that
they already have some form of inflation protection from current-law Social Security
benefits. If, however, these types of annuities were to be mandatory and
accompanied by the required reduction in Social Security benefits for IA participants,
the experience in the United Kingdom indicates that it is likely that such a market
would develop.15
Analysis of the President’s 2005 IA Proposal
Although the President’s IA proposal would worsen Social Security solvency
within the next 75 years, in the long-run, the shadow accounts and the resulting
offsets in Social Security defined benefits would reduce benefit costs to the current-
law program. Because of the short-run costs, and barring other benefit reductions or
tax increases, the IA proposal is likely to increase publicly held debt and increase the
unified budget deficit. Under the President’s IA proposal, younger workers and
higher earners who can contribute to the IA for longer periods of time or contribute
larger amounts to the IA would have larger IA balances and annuities than those who
contribute over fewer years or contribute fewer dollars. As a result of the larger IA
balances, younger workers and higher earners would have a lower Social Security
defined benefit. Whether a worker does better under the individual account proposal
depends on whether he or she is able to obtain a higher annual rate of return (net of
administrative expenses) than the 3.0% real rate of return used to calculate the
shadow account.
Although these individual accounts are likely to make the solvency problem
worse, the President has not yet specified how this additional shortfall will be
financed. It could be financed through (1) increased government borrowing (to be
paid off eventually through general revenues); (2) increased payroll taxes or other tax
increases; or (3) additional benefit reductions. CRS has provided estimates of
combined Social Security income under two scenarios: one where it is assumed that
trust fund revenues are found and the trust fund can provide “scheduled” current law
Social Security benefits, and one where it is assumed that trust fund revenues are not
found and the current-law benefit is reduced to a “payable” level based on estimated
current-law revenues. However, because the Social Security Administration
actuaries were not provided with the plan specifications needed to produce a 75-year
analysis of how the President’s IA proposal would affect solvency, the size of the
annual benefit reductions that would be required to maintain trust fund solvency
under a payable baseline is not known. Therefore, the results below do not take into


15 Brown, Jeffrey, Olivia Mitchell and James Poterba, The Role of Real Annuities and
Indexed Bonds in an Individual Accounts Retirement Program, National Bureau of
Economic Research, Working Paper no. 7005, Mar. 1999.

account the benefit reductions on top of those required under current-law and under
the “shadow” account offset that would be necessary under the President’s IA
proposal to achieve solvency. Thus, this analysis tends to overstate the combined
Social Security income that would be available under the IA proposal compared to
a current-law payable baseline. However, the total Social Security income possible
for a scaled average-wage worker using the ‘expected’ 4.6% annual real rate of return
would be 31% higher than current-law payable benefits for younger cohorts.16 Thus,
if the additional benefit reductions required to achieve solvency under the IA plan
reduce benefits by less than 31%, scaled average-wage workers under the IA plan
would still come out ahead. One important limitation of using these assumed
constant annual interest rates is that historical rates of return have not followed such
a pattern. Interest rate fluctuations over time and where these fluctuations occur in
a worker’s career can have a large effect on the estimated account balances of
workers under an IA system.
Effect on Social Security Solvency
Administration officials acknowledge that the proposed individual accounts
alone do not improve the Social Security solvency problem. In the short-run, these
individual accounts are likely to make the solvency problem worse. The President’s
plan permits individuals to contribute up to 4 percentage points (up to a dollar
contribution limit) of the current 12.4% payroll tax into individual accounts, thus
diverting current revenues away form the traditional Social Security system. By
itself, this step would worsen the Social Security solvency problem because these
dollars are taken from the Social Security surpluses and therefore the Trust Funds
don’t accrue the same balances that they otherwise would have and they also earn
less interest on these reduced balances. Not including the lost interest earnings, the
cost to the Trust Funds between 2005 and 2015 would be approximately $541 billion
in constant 2004 dollars.17 By the end of 2015, the IA proposal would increase
publicly-held debt by $587 billion in 2004 dollars. The second piece of the
President’s IA proposal, the reduction in Social Security benefits based on the
“shadow” account, has the effect of offsetting the cost of the IA proposal and
potentially improving the solvency problem in the long run. However, because this
reduction only takes place upon a worker’s retirement, but the contributions to the
IA begin almost immediately and continue up to the worker’s year of retirement, the
savings from the benefit offset takes many years to counter the loss of revenue to the
Trust Funds from the IA itself. Between 2005 and 2015, these offsets reduce Social
Security benefits by only $3 billion constant 2004 dollars. The Social Security
actuaries estimate that the year in which Social Security costs exceed Social Security
tax revenue would be 2012 under the President’s proposal instead of 2017 under
current law.


16 For details on “scaled” wage workers, please refer to the Methodology section.
17 Social Security Administration Memorandum to Charles P. Blahous, Special Assistant
to the President for Economic Policy, National Economic Council from Stephen C. Goss,
Chief Actuary, “Preliminary Estimated Financial Effects of a Proposal to Phase In Personal
Accounts — INFORMATION,” Feb. 3, 2005.

If, as indicated in the actuarial memorandum, disability recipients are not subject
to the “shadow” account offset (presumably because disabled workers would not
have access to their accounts until their disability benefits convert to aged retirement
benefits at the full retirement age), then the Trust Funds would be made worse off
because they would still have the burden of paying full Social Security benefit
amounts to disability recipients (who are by definition under the retirement age) even
though these individuals may have participated in the IA system, thereby reducing
the revenues available to pay these benefits. The actuarial memorandum implies that
disabled individuals would be subject to the offset upon conversion from disability
benefits to retirement benefits at the full retirement age, reducing the cost of their
benefit payments from that point on.
The actual effect of the President’s proposal on solvency is dependent upon the
number of individuals who participate in the system of individual accounts and upon
their level of earnings. The Social Security actuaries assume that approximately two-
thirds of all eligible workers will opt-in to the account system. The actuaries do not
attempt to predict what types of workers (e.g., high wage, low wage, etc.,) would
participate in the IA system, but instead rely on estimates of the aggregate dollar
amounts that would likely be diverted from current payroll taxes. The larger the
number of individuals who participate in the accounts, the greater the dollar amount
diverted away from the current Social Security system, and the greater the up-front
negative impact on Social Security solvency. Of course, the greater the number of
individuals who choose to participate in the IA system, the greater the eventual
reduction in benefits promised to these individuals under the current Social Security
system and the greater the potential long-term enhancement to Social Security
solvency.
The Social Security actuaries, who estimate the effect of Social Security reform
proposals on solvency, were unable to produce the standard 75-year estimate of the
effect of the President’s proposal because they were only given specifications through
2015. However, based on a similar individual account structure introduced by
Senator Lindsey Graham as part of a larger reform proposal in the 108th Congress (S.

1878) and analyzed by the Social Security actuaries, it seems likely that over a 75-


year period the President’s individual account proposal would not pay for itself
through benefit offsets, nor reduce the existing solvency problem.18 In present value
terms, Senator Graham’s individual account proposal alone would have added $2.7
trillion in constant 2004 dollars to the $4.0 trillion current-law Social Security
shortfall.19


18 The default option under Sen. Graham’s plan was an individual account funded by a
carve-out equal to 4% of the current payroll tax, with contributions capped at $1,300 in 2006
and increased with the percent increase in the national average wage thereafter. The benefit
offset was calculated using account contributions grown at a real annual interest rate of

2.7%.


19 The Congressional Research Service (CRS) calculation based on Social Security
Administration Memorandum from Chris Chaplain and Alice H. Wade to Stephen C. Goss
on the “Estimated OASDI Financial Effects of ‘Social Security Solvency and Modernization
Act of 2003’ introduced by Senator Lindsey Graham — INFORMATION,” Nov. 18, 2003.
(continued...)

Some individual account proposals, such as that introduced by Representative
Shaw (H.R.750 in the 109th Congress), use the actual individual account to provide
revenue to the Social Security Trust Fund to pay Social Security benefits. The
individual is still responsible for investing the IA assets, but instead of reducing the
Social Security benefit based on contributions to the IA, the actual IA is handed over
to the government for use in paying for the individual’s Social Security benefits. The
Social Security benefit payments are fixed, but the rate of return earned by each
individual worker on his or her account, and thus the account balance, is subject to
fluctuation. Thus, the Trust Fund is subject to the risk that the individual accounts
will not be invested in a way that produces sufficient revenue to pay for an
individual’s lifetime benefits. Alternatively, the President’s proposal provides the
Trust Funds with a guaranteed source of revenue in the form of reduced benefit
costs, which is equal to the individual’s IA contributions grown at a real annual 3%
interest rate. Therefore, the Trust Funds are not subject to any investment risk. With
the lower “traditional” Social Security benefits, the President’s proposal also lowers
the impact on the Trust Funds from the costs of unexpected increases in inflation or
longevity. Individuals are responsible for purchasing an annuity (in which case these
risks are shifted to the insurance company that sold the annuity) or making phased
withdrawals (in which case these risks are borne by the individual).
Effect on the Unified Budget
The unified budget (the combined on- and off-budget) could be affected by this
proposal in two ways. First, if the government relies on general revenues to
reimburse Social Security for the loss of revenue due to the diversion of funds for the
IA, the Treasury would need to either increase tax revenues, reduce other government
spending, or increase government debt. According to the Office of Management and
Budget, the President’s IA proposal will require transition financing of $664 billion
over the next 10 years, or $754 billion including interest if additional debt is issued
to cover these costs.20 Second, as Figure 1 below illustrates, diverting Social
Security revenues into individual accounts reduces the Social Security surplus,
thereby reducing the off-budget surplus. Social Security surplus dollars are not held
by the Social Security Trust Funds. Rather, according to law, surplus receipts are
credited to the Social Security Trust Funds in the form of special-issue non-
marketable Treasury bonds. The actual surplus dollars are held by the U.S. Treasury
where they become part of the general revenue pool and can be used to increase
spending, reduce taxes, or reduce the government debt.21 In recent years, Social
Security surpluses have been used to offset increased spending or reduced taxes since


19 (...continued)
For details on how CRS calculated this estimate, please refer to CRS Report RS22010,
Social Security: ‘Transition Costs’, by Laura Haltzel.
20 “Strengthening Social Security for the 21st Century,” White House, Feb. 2005, available
at [http://www.whitehouse.gov/infocus/social-security/200501/strengthening-socialsecurity
.html]. For additional information on transition costs, see CRS Report RS22010, Social
Security: Transition ‘Costs’, by Laura Haltzel.
21 For additional information on how Social Security financing works, please refer to CRS
Report 94-593, Social Security: Where Do Surplus Taxes Go and How Are They Used?, by
Geoffrey Kollmann.

the rest of the government’s budget (on-budget) has been in deficit. Thus, any
reduction in the Social Security surplus (off-budget) would, barring other changes,
lead to an increased unified budget deficit.
Figure 1. Effect of the President’s Individual Account Proposal on
Projected Social Security Surpluses
(Billions of current dollars)


350Current law social security
surplus
300Social security surplus under
sIA plan
250llarReduction in the Social Security
oSurplus Under the President's
D
Individual Account Plan
200rent
r
u
C
150f
s o
100illion
B
50
0
2005 2006 2007 2008 2009 2 010 2011 2012 2 013 2014 2015
Year
Source: Congressional Research Service (CRS) Calculations based on the 2004 Social Security
Trustees Report, Table VI.F.9 and the Feb. 3, 2005 Social Security Actuarial Memorandum to Charles
Blahous, Table 1.b.2.
Note: The 2004 Social Security Trustees Report is used because this was the basis for the estimates
provided in the Social Security memorandum to Charles Blahous.
Effect on Combined Social Security Income
Based on the assumptions and methodology described below, CRS finds that the
total of the reduced Social Security defined benefit plus the annuity that would be
available using the actual IA balance would exceed Social Security current-law
promised benefits if the account earns the 4.6% annual real rate of return projected
by the Social Security actuaries. However, if the account earns the 2.7% risk-
adjusted annual real rate of return projected by the actuaries, workers would face a

slight reduction in overall Social Security income relative to current law.22 Younger
workers and those with higher lifetime earnings would benefit the most from IAs.
Younger workers would be able to contribute to their IA throughout their careers and
would have higher contributions as a result of continued wage growth. Higher
earners would benefit from being able to accrue larger account balances as the dollar
limit on contributions increases over time until it reaches the full 4% of covered
wages.
How an individual worker would fare under the IA proposal would depend
entirely upon how the actual rate of return earned by the worker’s IA compared to the
fixed “benefit offset” rate of 3%. The worker would bear all of the investment risk.
If a worker’s actual account attained an annual real rate of return greater than 3%, the
balance of the actual account would be higher than that of the “shadow” account.
Thus, while the Social Security benefit would be reduced by the annuity based on the
“shadow” account, an annuity from the actual account would be larger and would
more than offset the reduction to the defined benefit. Therefore, the combined actual
individual account annuity plus the Social Security benefit reduced by the “shadow”
account would be larger than what the worker is scheduled to receive under current
law. On the other hand, if a worker’s actual account attained an annual real rate of
interest lower than 3%, the balance of the actual account would be lower than that of
the shadow account. Thus, while the Social Security benefit would be reduced by the
annuity based on the “shadow” account, an annuity from the actual account would
be smaller and would not offset the reduction to the worker’s Social Security benefit.
Therefore, the combined actual IA annuity plus the Social Security benefit reduced
by the “shadow” account would be smaller than what the worker is promised to
receive under current law. Because the hypothetical account rate of return (3.0%) is
not reduced by administrative fees while the actual risk-adjusted rate of return is
reduced by administrative fees (to 2.7%), the hypothetical account balance will
exceed that of the risk-adjusted actual account in every case where the worker invests
exclusively in government bonds as a way to “opt-out” of the IA system.
According to the actuarial memorandum, disability beneficiaries would not be
subject to the offset and would not have access to their IA until conversion from
disability benefits to aged retirement benefits at the full retirement age. The
memorandum also indicates that the offset applies to all aged retirement benefits. If
disability recipients were subject to the offset upon conversion, then these workers
would experience a sudden change in the composition of their benefit from one of a
guaranteed benefit to one that is partially guaranteed and partially dependent on the
proceeds from the IA.


22 The higher rate of return one expects to earn from investing in stocks is due to the higher
risk such an investment carries. The difference between the rate of return on stocks and the
rate of return on government bonds is known as the “risk premium,” the amount of
compensation the market demands for taking on the additional risk of investing in stocks
relative to the lower risk of investing in government bonds. In this case, because stocks are
assumed to earn a real rate of return of 6.5% while government bonds are assumed to earn
a real rate of return of 3% the risk premium is 3.5 percentage points. Thus, the “risk-
adjusted” rate of return used in this analysis represents the stock rate of return adjusted
downward by this risk premium. This rate of return omits any expected return over that of
government bonds.

Limitations of This Analysis. According to the 2004 Trustees Report (the
source of the assumptions used for this analysis), under current law, Social Security23
will be unable to fully pay promised benefits after 2042. Estimates of combined
Social Security income are provided under two scenarios: one where it is assumed
that trust fund revenues are found and the trust fund can provide “scheduled” current
law Social Security benefits, and one where it is assumed that trust fund revenues are
not found and the current-law benefit is reduced to a “payable” level based on
estimated current-law revenues. In the “scheduled” benefits scenario, the benefit
estimates for both the current-law benefit and the Social Security benefit under the
President’s IA assume the use of yet unidentified sources of revenue. A comparison
of the ‘payable’ baseline to the scheduled baseline shows to what degree the current-
law scheduled benefits are overstated compared to current-law revenue sources.
Because the individual accounts would actually make the Social Security solvency
problem worse in the short run, to achieve solvency without revenue increases the
President’s proposal would require larger benefit reductions than those that would
be required to achieve solvency under current law unless the entire transition cost
were financed through increased debt or higher taxes. However, because the Social
Security Administration actuaries were not provided with the plan specifications
needed to produce a 75-year analysis of how the President’s IA proposal would affect
solvency, the size of the annual benefit reductions that would be required to maintain
trust fund solvency is not known. Thus, a serious limitation of the “payable” analysis
is that it overstates the value of the total Social Security income available under the
IA plan because it fails to take into account the additional solvency-driven reductions
(on top of the “shadow account” offset) to the Social Security defined benefit that
forms the base of Social Security combined income.
Figure 2 shows that the total Social Security income possible for a scaled
average-wage worker using the assumed 4.6% annual real rate of return would be
31% higher than current-law payable benefits for younger cohorts. Thus, if the
additional benefit reductions required to achieve solvency under the IA plan reduce
benefits by less than 31%, scaled average-wage workers who achieve the “expected”

4.6% annual rate of return under the IA plan would still come out ahead. However,


if the ultimate benefit reductions are greater than 31%, workers would have higher
benefits under current-law. Figure 2 also shows that the total Social Security income
possible for a scaled average-wage worker using the risk-adjusted 2.7% annual real
rate of return would be about 4% lower than current-law payable benefits for younger
cohorts. Thus, any additional benefit reductions required to achieve solvency under
the IA plan would make these scaled average-wage workers worse off than under
current-law.


23 The 2005 Social Security Trustees Report indicates that the year of exhaustion of the
OASDI Trust Funds in 2041. To maintain consistency with the underlying assumptions
used in this analysis, CRS has continued using 2042 as the date of exhaustion for the
“payable” baseline estimates.

Figure 2. Percent Difference Between Current-Law Payable
Social Security Benefits and Total Social Security Income
(Reduced Current-Law Payable Social Security Benefits Plus
the Individual Account Annuity)
35%
30%
25%
Percent Difference Between
20%Current-Law PAYABLE and TotalSocial Security Income Assuming
'Expected' 4.6% Annual Real Rate of
15%t Return on IA
cenPercent Difference Between
10%PerCurrent-Law PAYABLE and TotalSocial Security Income Assuming
'Risk-Adjusted' 2.7% Annual Real
5%Rate of Return on IA
0%
Age 41Age 31Age 21Age 11Born TodayBorn 2012
-5%
-10%
Birth Cohort
Source: Congressional Research Service estimates.
Although it is not yet known how the additional shortfall due to the IAs will be
financed, it would require at least the same solvency-driven reductions that would be
required under a “do-nothing” scenario where only those benefits that can be paid
with incoming tax revenues would be paid. In this analysis, these estimates are
presented as “payable” benefits. According to the 2004 Trustees Report (the source
of the assumptions used for this analysis), under current law, Social Security will be24
unable to fully pay promised benefits after 2042. At that time, payroll tax revenues
and revenues from the income taxation of Social Security benefits are projected to
be sufficient to pay approximately 74% of scheduled benefits and a gradually
declining percentage thereafter. Thus, under current law a benefit reduction of
approximately 26% would be required in 2042, with gradually increasing reductions
thereafter. In the examples presented below, only the worker age 21 today would
have any change in Social Security benefits under the payable baseline as this
worker’s year of retirement (2051) occurs after the Trust Funds have been depleted
and annual Social Security revenues are sufficient to pay only 74% of promised


24 The 2005 Social Security Trustees Report indicates that the year of exhaustion of the
OASDI Trust Funds in 2041. To maintain consistency with the underlying assumptions
used in the Social Security actuarial analysis of the President’s IA proposal, CRS has
continued using 2042 as the date of exhaustion for the “payable” baseline estimates.

benefits. Thus, under the payable baseline, the 21-year-old’s Social Security
promised benefits are reduced by 26%.
For a series of hypothetical workers that vary by age and earnings history, the
following section provides estimates of
!the worker’s actual and “shadow” individual account balances;
current-law promised Social Security benefits;
!benefit offsets based on the “shadow account” annuities; reduced
promised Social Security benefits;
!the total reduced Social Security/IA benefit relative to the Social
Security benefit promised under current law;
!the total reduced Social Security/IA benefit relative to the Social
Security benefit payable under current law;
!required annuitization or phased withdrawal levels with reduced
Social Security promised benefits;
!maximum amounts available at retirement as lump-sum or
inheritance amounts with reduced Social Security promised benefits
once the required annuitization or phased withdrawals have been
deducted;
!required annuitization or phased withdrawal levels with reduced
Social Security payable benefits;
!and, maximum amounts available at retirement as lump-sum or
inheritance amounts with reduced Social Security payable benefits
once the required annuitization or phased withdrawals have been
deducted.
Because account balances and benefit reductions will differ by age and lifetime
earnings, estimates for hypothetical low, average and high-wage earners born in
various years (i.e., of various birth cohorts) are provided.
Analysis by Birth Cohort. Assuming a 4.6% annual real rate of return,
younger birth cohorts participating in the IA system would receive a larger total
Social Security income (composed of the reduced Social Security benefit plus the IA
annuity) compared with older cohorts of similar earnings levels (e.g., scaled low-
wage worker). Figure 3 shows combined Social Security income for scaled
average-wage workers of different birth cohorts.



Figure 3. Total Social Security Income for Scaled Average-Wage
Worker, by Birth Cohort


Source: Congressional Research Service estimates.
Younger workers will have higher individual account balances than will older
workers of similar earnings levels. As is evident from Table 3, those workers who,
as a result of their age, are able to contribute to their IA throughout their careers have
much larger account balances upon retirement than do those who contribute at the
same earnings level, but over fewer years. For example, upon retirement, the
“expected” individual account balance of the average worker age 41 today is only
27% of that of the average worker age 21 today. Based on the assumptions used in
this analysis, the increased account balance for younger generations is due to three
variables: (1) the rise in real wages for individuals of similar earnings levels, and thus
real contributions to the accounts; (2) the higher value of interest accumulated due
to these higher wages; and, (3) the increasing number of years of contributions to the
accounts and the effect of more years of interest (up to the point where each future
cohort would have contributed to the IA for each of their 44 work years, the 1990
birth cohort). First, under the assumptions used by the Social Security actuaries, each
future generation will earn real wages (i.e., an increase in earnings that is greater than
the increase in inflation) larger than those of the generation before it.25 Thus, the real
contributions to the IA of each future generation will also be larger than those of the
current generation. Second, these larger real contributions create a larger real
account base for investment. Even with the same annual real rate of return applied
25 The Social Security actuaries assume long-term average real wage growth of 3.9% per
year.

(e.g., 4.6%) to the IA between different generations, the dollar value of the interest
is higher with the higher real account base. Third, the 41-year-old worker
participates in the account for only 22 years (2009-2030) whereas the 21-year-old
participates for 40 years (2011-2050). The younger worker’s greater of number of
years participating in the IA leads both to greater aggregate contributions and greater
interest earnings as a result of the increased years of investment of those
contributions.
Because younger workers will have both larger actual accounts as well as larger
“shadow” accounts, younger workers face a larger offset to their Social Security
promised benefits relative to older workers. Table 4 illustrates that depending on
age, the “shadow” account annuity reduces Social Security promised benefits by
between 17% and 41% for the scaled average-wage worker.
The effect of the benefit offset in reducing the Social Security benefit is larger
for younger cohorts whose Social Security benefits could be reduced to achieve long-
term solvency. Table 5 provides the same information as for Table 4, but for a
baseline of current-law Social Security payable benefits instead of promised benefits.
Only the worker age 21 today would have any change in Social Security benefits
under the payable baseline as this worker’s year of retirement (2051) occurs after the
Trust Funds have been depleted and annual Social Security revenues are sufficient
to pay only 74% of promised benefits. Thus, under the payable baseline, Social
Security promised benefits are reduced by 26%. Because the Social Security benefit
is lower under the payable baseline, but the “shadow” account offset remains the
same, the percent reduction in Social Security benefits is larger than under the
promised baseline. Thus, in the long-run, workers would receive an increasingly
smaller portion of their Social Security defined benefit.
Younger workers would experience the largest percent increase in total Social
Security income if a 4.6% annual real rate of return is achieved. Table 6
demonstrates that the total of the reduced Social Security benefit plus the annuity that
would be available using the actual IA balance would exceed Social Security current-
law promised benefits if the account earns the “expected” 4.6% annual real rate of
return. Depending on age, the percent increase in combined Social Security income
is estimated to be between 3% and 18% for the scaled average-wage worker. The
percent increase in the total benefit amount is larger for younger workers who
contribute to the IA for their entire careers and thus have more years for the
difference in interest rates between the hypothetical account and the actual account
to work in their favor. If, on the other hand, the account is only able to achieve a

2.7% annual real rate of return (the annual real annual rate of 3.0% minus 0.3%


administrative costs), then the total of the reduced Social Security benefit plus the
annuity would be less than that promised under current-law. The advantages for
younger workers would be removed under this “risk-adjusted” interest rate as there
is no percentage point difference to be utilized to enhance the longer IA participant’s
account balance.
Younger workers would experience an even larger percent increase in combined
Social Security income when compared to what would be possible under a current-
law payable scenario. Table 7 provides the same information as Table 6, but for a
benefits payable baseline. Again, the only worker that would be affected by the



payable baseline is the worker age 21 today. Because the current-law payable benefit
would be lower than the current-law promised benefit, the same dollar amount from
the IA annuity (assuming a 4.6% annual real rate of return), would lead to a larger
percent increase in combined Social Security income for this worker.
Analysis by Earnings Level. Assuming a 4.6% annual real rate of return,
higher-wage workers would experience a greater percent increase in combined Social
Security income than lower-wage workers. Figure 4 below demonstrates the levels
of current-law promised benefits, the combined Social Security income assuming an
annual real rate of return of 4.6%, and the combined Social Security income
assuming an annual real rate of return of 2.7% for a worker age 21 today with three
different lifetime earnings levels.
Figure 4. Effect of the President’s IA Proposal on Combined Social
Security Income, by Earnings Level for Worker Age 21 Today
$3,500
$3,107
$3,000
$2,652 $2,585
$2 ,3 65$2,500
$2,008 $1,957$2,000
$1,379 $1 ,2 16 $1,192$1,500
$1,000
Constant 2005 Dollars
$500
$-
Scaled Low-Wage WorkerScaled Average-Wage WorkerScaled High-Wage Worker
Type of Hypothetical Worker, Age 21Today
TOTAL Social Security Income Assuming an 'Expected' 4.6% Annual Real Rate of Return
(Reduced Social Security PROMISED Benefit and IA Annuity)
Current-Law Promised Social Security Benefit
TOTAL Social Security Income Assuming a 'Risk-Adjusted' 2.7% Annual Real Rate of Return
(Reduced Social Security PROMISED Benefit and IA Annuity)
Source: Congressional Research Service estimates.
Note: Compares benefit amounts assuming funding is located to pay Social Security promised
b e ne fits.
IA participants with higher earnings over their lifetime will have larger account
balances when they retire than those of lower earners. Those with higher wages are
able to contribute larger dollar amounts to their IAs leading to larger account
balances. For example, in Table 3 the scaled low-wage earner age 41 today has only
44% of the account balance of the scaled high-wage earner age 41 today. Even
though these workers contribute to the IA over the same number of years, and even
though the high-wage earner is subject to the contribution cap for 15 years out of the



22 spent participating in the IA, 4% of the high-wage worker’s salary is larger than
4% of the low-wage worker’s salary. The disparity in account balances between
individuals with different earnings levels increases over time as the cap on IA
contributions rises to the point where the hypothetical high-wage worker could
contribute a full 4% of wages to the IA. By the time a worker age 21 today retires,
the account balance of a low-wage worker equals only 34% of that of a high-wage
worker of the same age.
Because of their larger account accumulations, higher earners would face a
larger percent reduction in their Social Security scheduled benefits as a result of the
benefit offset. Table 4 illustrates that depending on earnings level, the “shadow”
account annuity reduces Social Security promised benefits by between 31% and 43%
for a worker age 21 today. Low earners face smaller percent reductions to their
Social Security promised benefits than do higher earners because the underlying
Social Security benefit structure is progressive (i.e., it replaces a larger percentage of
wages of low-wage workers compared to high-wage workers). Thus, a flat
percentage of each workers wages (4%), grown at a flat percentage rate each year
(3%) to arrive at the “shadow” offset, still maintains the progressive benefit structure
by allowing low-wage workers to keep a larger percentage of their Social Security
benefit (e.g., 69% for the age 21-year-old) than high-wage workers (e.g., 57% for the
age 21-year-old).
Higher earners (scaled high and scaled average wage workers) would experience
the largest percent increase in total Social Security income if a 4.6% annual real rate
of return is achieved. Table 6 demonstrates that the total of the reduced Social
Security benefit plus the annuity that would be available using the actual IA balance
would exceed Social Security current-law promised benefits if the account earns the
“expected” 4.6% annual real rate of return. Depending on earnings level, the percent
increase in combined Social Security income is estimated to be between 13% and
18% for a worker age 21 today. Under the 4.6% rate of return scenario, the percent
benefit increase would be larger for scaled high-wage workers than for scaled low-
wage workers. This difference would occur because the 4% of earnings that high
earners would be able to contribute to their IAs has a larger dollar value and would
be able to take advantage of the 1.6 percentage point difference between the 4.6%
rate of return on the IA and the 3.0% rate of return used to calculate the IA benefit
offset. If, on the other hand, the account is only able to achieve a 2.7% annual real
rate of return (the annual real annual rate of 3.0% minus 0.3% administrative costs),
then the total of the reduced Social Security benefit plus the annuity would be less
than that promised under current-law. The advantages for higher earners would be
removed under this “risk-adjusted” interest rate as there is no percentage point
difference to be utilized to enhance the higher earner’s account balance.
As Table 8 illustrates, the reduced Social Security promised benefit is still large
enough compared to the monthly aged poverty thresholds to allow each hypothetical
worker the option of withdrawing the entire IA balance as a lump-sum at retirement,
rather than being required to purchase an annuity or take programmed withdrawals,
or passing it on as an inheritance. If, however, additional benefit reductions are
eventually introduced as part of a comprehensive Social Security proposal, some
portion of the IA balance would probably need to be annuitized or taken as a phased
withdrawal in order to achieve a combined monthly stream of income equal to the



federal poverty threshold. This outcome is best demonstrated in Table 9, which
takes into account the effect of a reduction in promised benefits for the 21 year old
to provide only those benefits payable at retirement. In this case, the low-wage and
average-wage worker’s payable benefits fall below the poverty threshold after being
reduced by the “shadow” account annuity. As a result, this worker would be required
to annuitize or take in programmed withdrawals enough of the individual account to
guarantee a combined Social Security income equal to 100% of the federal poverty
threshold. Once this portion of the individual account has been annuitized or set
aside for programmed withdrawals, the worker would have the option to take the
remainder of the account balance as a lump sum or pass it along as inheritance. The
high-wage 21-year-old worker would not be required to annuitize or set aside for
programmed withdrawals any portion of his or her account balance because even the
26% reduction in Social Security benefits under the payable baseline leaves this
worker with a large enough Social Security benefit to remain above the federal
poverty threshold. Thus, if benefit reductions are the primary method of achieving
long-term solvency, lower- and average-wage workers would be less able to increase
family wealth under the President’s IA plan than would high-wage workers.
Methodology
All individual account estimates are based on the proposal specifications
outlined above. To estimate the account balances of the actual and hypothetical
“shadow” accounts for those retiring many years in the future, CRS assumes that the
IA contribution limit continues to increase over the full work history of each worker
according to the method outlined in the actuarial memorandum. If further details
emerge that alter this contribution rate, these estimates would need to be recalculated
accordingly. CRS estimates the account balances for the actual IA, which the worker
will receive in full, using both the “expected” annual real rate of return specified by
the Social Security actuaries (4.9%) as well as the “low-yield” or “risk-adjusted”
annual real rate of return specified by the actuaries (3.0%), both reduced by the
estimated administrative fee of 30 basis points per year. Thus the annual real rate of
return net of administrative costs is 4.6% and 2.7%, respectively. The hypothetical
account balance is estimated using the 3.0% rate of return specified in the proposal.
This account balance is used to calculate the offset to the Social Security defined
benefit. Because the hypothetical account rate of return is not reduced by
administrative fees whereas the actual risk-adjusted rate of return is reduced by
administrative fees, the hypothetical account balance will exceed that of the risk-
adjusted actual account in every case. To calculate the CPI-indexed annuity for both
the actual and hypothetical “shadow” accounts, annuity factors provided by the
Social Security Administration were used.
One important limitation of using these assumed constant annual interest rates
is that historical rates of return have not followed such a pattern. Interest rate
fluctuations over time and where these fluctuations occur in a worker’s career can
have a large effect on the estimated account balances of workers under an IA system.
For example, a negative rate of return in the years prior to an individual’s retirement
can significantly reduce the value of the assets in the IA. Similarly, the rate of return
prevalent at the time of retirement can alter the monthly annuity payment that a



worker would receive based on the same dollar amount in the individual account.
The higher the interest rate assumed when calculating the annuity amount, the greater
the assumed earnings on the assets used to fund the annuity, and the larger the
annuity payment to the worker. For example, based on CRS analysis, at an interest
rate of 6.0%, a 68-year-old person who purchased a level, single-life annuity for
$200,000 would receive income from the annuity of $1,852 per month. At an interest
rate of 4.0%, the same sum of money would buy a level, single-life annuity worth
$1,584 per month, a difference of $268 in monthly income.
Some have argued that the establishment of individual accounts, as well as the
tax increases, benefit reductions or government borrowing needed to achieve
solvency, may affect the macroeconomy and, thus, affect the interest rates that
individuals could expect to obtain on their IAs. These estimates do not incorporate
any such potential macroeconomic feedbacks.
The effect of the proposal is estimated both on workers who would contribute to the
IA for their entire career as well as those whose careers would be split between the
current-law system and the IA system. To estimate the effect of the IA proposal on
a worker age 21 today, CRS assumes that the worker is born in 1984, begins work
at age 21 in 2005, and retires at the full retirement age of 67 in 2051. As a result, this
worker spends 40 years of his or her 46 year work history contributing to the IAs and
reflects what the system could provide to a worker once the plan is fully phased-in.
To estimate the effect of the IA proposal on a worker age 31 today, CRS assumes that
the worker is born in 1974, begins work at age 21 in 1995, and retires at the full
retirement age of 67 in 2041. As a result, although this worker also has a career of
46 years, only 30 of them are spent contributing to the IA. Finally, to estimate the
effect of the IA proposal on a worker age 41 today, CRS assumes that the worker is
born in 1964, begins work at age 21 in 1985, and retires at the full retirement age of
67 in 2031. Thus, this worker also has a career of 46 years, but only 22 of them are
spent contributing to the IA.
Account balance estimates for scaled low-wage workers, scaled-average wage
workers, and scaled high-wage workers, as defined by the Social Security Office of
the Chief Actuary are provided.26 It is assumed that these workers follow typical
lifetime earnings patterns that would produce a Social Security benefit equivalent to
that of workers with career earnings of either: (1) a “low”wage (45% of a wage equal
to Social Security’s “average wage series”); (2) an “average wage”(a wage equal to
Social Security’s “average wage series”); or, (3) a “high” wage (160% of a wage
equal to Social Security’s “average wage series”). For example, based on projections
in the 2004 Social Security Trustees Report, a worker retiring in 2005 would have
had career average earnings of $15,776 for a scaled “low” earner, career average
earnings of $35,057 for a scaled “average” earner, and career average earnings of


26 Social Security Administration, Office of the Actuary, Internal Rates of Return Under the
OASDI Program for Hypothetical Workers, Actuarial Note No. 144, June 2001. The pattern
in these “scaled” earnings histories shows relatively low earnings at the beginning of the
career, fairly rapid growth through the middle of the career, and a gradual tapering off of
earnings at the end of the career.

$56,091 for a scaled “high” earner.27 These scenarios are for illustration only and are
not meant to fully represent every possible scenario that actual workers may
experience. For example, by relying on stylized workers, no gaps in employment are
assumed. If present, these gaps would reduce both the Social Security benefit and the
IA balance of these workers. However, because under a system of individual
accounts the earlier contributions are made the more interest they accrue, the timing
of gaps in employment has a greater effect on individual account balances than they
would on the traditional Social Security benefit level. Although the plan does not
require annuitization, but allows individuals to take programmed withdrawals from
their IAs, CRS has followed the Social Security Administration’s practice of
assuming universal annuitization as it is not clear which type of worker might opt for
programmed withdrawals. Because hypothetical workers with no spouses or other
dependents are used, the annuity levels calculated for both the actual and hypothetical
accounts are based on the purchase of a unisex CPI-indexed single-life annuity
assuming an inflation rate of 2.8% per year and a nominal interest rate of 5.884% per
year. Furthermore, the poverty level estimates for the year of retirement are also
based on a single-person household. The aged poverty level in 2004 was $9,060.
This level was indexed to the year of retirement using the CPI. Unless otherwise
specified, all assumptions are based on the 2004 Social Security Trustees Report.
Unless otherwise specified, all dollar amounts are presented in real 2005 dollars.


27 Career average earnings levels are defined for retired workers as the highest 35 years of
earnings, indexed for growth in average wages to the year prior to benefit entitlement. This
concept is similar to that of the AIME, except that career average earnings for these scaled
workers are indexed to the year prior to entitlement instead of two years prior to eligibility
and earnings are averaged on an annual rather than a monthly basis. Thus, the indexing year
for the 2005 retiree is 2004, and the 2004 average wage index is the basis for the career
average earnings levels for each hypothetical worker.

CRS-24
ccount Balances in Year of Retirement for Actual and “Shadow” Account Under the President’s
2005 Social Security Personal Account Proposal, by Type of Hypothetical Worker
(Constant 2005 dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Individual AccountAge 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
today today today today today today today today today
$28,149 $54,441 $90,173 $52,798 $111,257 $198,541 $64,148 $139,246 $268,788
iki/CRS-RL32879t u r n )
g/w
s.or “Low-
leak Adjusted” 2.7% Annual$22,184$38,885$58,710$42,427$80,617$129,568$52,624$103,782$180,723
://wiki
http
$23,022 $40,960 $62,700 $43,895 $84,732 $138,328 $54,266 $108,590 $192,046
turn)
Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement at age 67 is 2051. For the worker age 31, the year of retirement at age 67 is 2041. For the worker age 41, the year of retirement
e 67 is 2031.



CRS-25
Promised Social Security Benefit, Estimated “Shadow” Annuity Amount in Year of Retirement,
and Reduced Promised Social Security Benefit, by Type of Hypothetical Worker
(Constant 2005 dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Individual AccountAge 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
today today today today today today today today today
Current-Law Promised Social$983$1,093$1,216$1,623 $1,805$2,008$2,144$2,384$2,652
Benefit
iki/CRS-RL32879 Annuity at
g/wtirement (First year, increasing with$142$248$371$271$512$820$336$657$1,138
s.orI each year of life expectancy)
leak
://wikimaining Monthly Social Securityised Benefit After Reduction by$840$846$844$1,352$1,293$1,189$1,808$1,728$1,515
http
hange in Current-Law Social
Promised Benefit Due to- 14%- 23%- 31%- 17%- 23%- 41%- 16%- 28%- 43%
Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement at age 67 is 2051. For the worker age 31, the year of retirement at age 67 is 2041. For the worker age 41, the year of retirement
e 67 is 2031.



CRS-26
Payable Social Security Benefit, Estimated “Shadow” Annuity Amount in Year of Retirement,
and Reduced Payable Social Security Benefit, by Type of Hypothetical Worker
(Constant 2005 dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Individual AccountAge 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
today today today today today today today today today
Current-Law Payable Social$983$1,093$900 $1,623$1,805$1,486$2,144$2,384$1,963
Benefit
Annuity at
iki/CRS-RL32879tirement (First year, increasing with$142$248$371$271$512$820$336$657$1,138
g/wI each year of life expectancy)
s.ormaining Monthly Social Security
leakable Benefit After Reduction by$840$846$528$1,352$1,293$667 $1,808$1,728$825
://wiki
httphange in Current-Law Social
Payable Benefit Due to- 14%- 23%- 41%- 17%- 23%- 55%- 16%- 28%- 58%
Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement at age 67 is 2051. For the worker age 31, the year of retirement at age 67 is 2041. For the worker age 41, the year of
ement at age 67 is 2031. Only the worker age 21 today would have any change in current-law Social Security benefits under a payable baseline (shown in bold) as this
ker’s year of retirement occurs at a point where annual Social Security revenues are sufficient to pay only 74% of promised benefits. These results do not take into account the
tional benefit reductions (on top of those due to the benefit offset and reductions to achieve solvency under current law) that would be necessary under the individual account
in order to achieve solvency under a payable baseline. Thus, these results tend to overstate the benefit levels that would be payable under the Presidents IA proposal. Please
r to accompanying memorandum for detailed description of methodology used.



CRS-27
Benefit For Expected and Risk-Adjusted Account Balances Under President’s
Individual Account Proposal Compared to Current-Law Promised Benefit, by Type of Hypothetical Worker
(Constant 2005 Dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Individual AccountAge 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
today today today today today today today today today
rrent-Law Monthly Social Security$983$1,093$1,216$1,623$1,805$2,008$2,144$2,384$2,652
OMISED Benefit
maining Monthly Social Security
OMISED Benefit After Reduction by$840$846$844$1,352$1,293$1,189$1,808$1,728$1,515
dow Annuity
nuity Available UsingExpected”Actual IA$174$329 $534$326$673$1,176$397$842$1,593
iki/CRS-RL32879lance (Using 4.6% annual rate of return)
g/wTAL (Reduced Social Security PROMISED$1,014$1,175$1,379$1,678$1,966$2,365$2,205$2,570$3,107
s.ornefit and IA Annuity)
leakrcent Increase or Decrease in Total Social
rity Income (Total reduced PROMISED3%7%13%3%9%18%3%8%17%
://wikinefit plus IA annuity relative to current law
httpOMISED benefit)
nuity Available Using Risk-Adjusted Actual
Balance (Using 2.7% Annual Real Rate of$137$235$348$262$488$768$325$628$1,071
tur n)
TAL Reduced Social Security PROMISED$977$1,081$1,192$1,614$1,781$1,957$2,134$2,355$2,585
nefit and Risk-Adjusted IA Annuity
rcent Increase or Decrease in Total Social
rity Income (Total reduced PROMISED- 1%- 1%- 2%- 1%- 1%- 3%0%- 1%- 3%
nefit plus Risk-Adjusted IA annuity relative
rrent law PROMISED benefit)
rce: Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement is 2051. For the worker age 31, the year of retirement is 2041. For the worker age 41, the year of retirement is 2031. Thus, only the 21-
old would be subject to benefit reductions under apayable baseline as this worker retires after the 2042 date when Social Security can only pay the portion of promised benefits equal to what
paid annually out of revenues generated by payroll taxes and the income taxation of Social Security benefits. Please refer to accompanying memorandum for detailed description of
y used.



CRS-28
Benefit For Expected and Risk-Adjusted Account Balances Under President’s
Individual Account Proposal Compared to Current-Law Payable Benefit, by Type of Hypothetical Worker
(Constant 2005 dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Age 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
toda y toda y toda y toda y toda y toda y toda y toda y toda y
rrent-Law Monthly Social Security PAYABLE Benefit$983$1,093$900$1,623$1,805$1,486$2,144$2,384$1,963
aining Monthly Social Security PAYABLE Benefit After Reduction$840$846$528 $1,352$1,293$667$1,808$1,728$825
Shadow” Annuity
nuity Available UsingExpected”Actual IA Balance (Using 4.6%$174$329 $534$326$673$1,176$397$842$1,593
l rate of return)
iki/CRS-RL32879TAL (Reduced Social Security PAYABLE Benefit and IA Annuity) $1,014$1,175$1,063$1,678$1,966$1,843$2,205$2,570$2,417
g/w
s.orrcent Increase or Decrease in Total Social Security Income (Total
leakuced PAYABLE benefit plus IA annuity relative to current law3%7%18%3%9%24%3%8%23%
YABLE benefit)
://wikinuity Available Using Risk-Adjusted Actual IA Balance (Using 2.7%
httpl Real Rate of Return)$137$235$348$262$488$768$325$628$1,071
TAL Reduced Social Security PAYABLE Benefit and Risk-Adjusted$977$1,081$876$1,614$1,781$1,434$2,13$2,355$1,896
Annuity
rcent Increase or Decrease in Total Social Security Income (Total
uced PAYABLE benefit plus IA annuity relative to current law-1%-1%-3%- 1%- 1%- 3%0%- 1%- 3%
YABLE benefit)
rce: Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement is 2051. For the worker age 31, the year of retirement is 2041. For the worker age 41, the year of retirement is 2031. Thus, only the 21-
-old would be subject to benefit reductions under apayable baseline as this worker retires after the 2042 date when Social Security can only pay the portion of promised benefits equal to what
paid annually out of revenues generated by payroll taxes and the income taxation of Social Security benefits. These results do not take into account the additional benefit reductions (on top of
e due to the benefit offset and reductions to achieve solvency under current law) that would be necessary under the individual account plan in order to achieve solvency under a payable baseline.
, these results tend to overstate the benefit levels that would be payable under the President’s IA proposal. Please refer to accompanying memorandum for detailed description of methodology
.



CRS-29
Table 8. Poverty Thresholds in Year of Retirement, Reduced Social Security Promised Benefit, Required
Annuitization Levels, and Remaining Individual Account Balance, by Type of Hypothetical Worker
(Constant 2005 dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Age 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
toda y toda y toda y toda y toda y toda y toda y toda y toda y
onthly Aged Poverty Threshold in Year of$766$766$766$766$766$766$766$766$766
tirement
maining Monthly Social Security PROMISED$840$846$844$1,352$1,293$1,189$1,808$1,728$1,515
nefit After Reduction byShadow” Annuity
iki/CRS-RL32879onthly Annuity Amount Needed to Achieve
g/w Poverty Level When Combined With$0$0$0$0$0$0$0$0$0
s.orduced Social Security PROMISED Benefit
leakrtion of Actual IA Required to be Annuitized
$0 $0 $0 $0 $0 $0 $0 $0 $0
://wikichieve 100% of Poverty
httpmaining Actual IA Balance (UsingExpected”
% Annual Real Rate of Return)$28,149$54,441$90,173$52,798$111,257$198,541$64,148$139,246$268,788
aining Actual IA Balance (UsingLow-
eld/ “Risk Adjusted 2.7% Annual Real Rate$22,184$38,885$58,710$42,427$80,617$129,568$52,624$103,782$180,723
Return)
Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement at age 67 is 2051. For the worker age 31, the year of retirement at age 67 is 2041. For the worker age 41, the year of
ent at age 67 is 2031. Please refer to accompanying memorandum for detailed description of methodology used.



CRS-30
erty Thresholds in Year of Retirement, Reduced Social Security Payable Benefit, Required Annuitization
Levels and Remaining Individual Account Balance, by Type of Hypothetical Worker
(Constant 2005 dollars)
Scaled Low EarnerScaled Average EarnerScaled High Earner
Age 41Age 31Age 21Age 41Age 31Age 21Age 41Age 31Age 21
toda y toda y toda y toda y toda y toda y toda y toda y toda y
onthly Aged Poverty Threshold in Year of$766$766$766$766$766$766$766$766$766
tirement
maining Monthly Social Security PAYABLE$840$846$528$1,352$1,293$667$1,808$1,728$825
nefit After Reduction byShadow” Annuity
iki/CRS-RL32879thly Annuity Amount Needed to Achieve 100%
g/wverty Level When Combined With Reduced$0$0$238$0$0$100$0$0$0
s.orrity PAYABLE Benefit
leakrtion of Actual IA Required to be Annuitized to
$0 $0 $40,185 $0 $0 $16,822 $0 $0 $0
://wikihieve 100% of Poverty
httpmaining Actual IA Balance (UsingExpected”
% Annual Real Rate of Return)$28,149$54,441$49,989$52,798$111,257$181,719$64,148$139,246$268,788
aining Actual IA Balance (Using Risk-$22,184$38,885$18,525$42,427$80,617$112,747$52,624$103,782$180,723
justed 2.7% Annual Real Rate of Return)
rce: Estimates by the Congressional Research Service.
For the worker age 21 today, the year of retirement is 2051. For the worker age 31, the year of retirement is 2041. For the worker age 41, the year of retirement is 2031. Thus, only the 21-
-old would be subject to benefit reductions under apayable baseline as this worker retires after the 2042 date when Social Security can only pay the portion of promised benefits equal to what
paid annually out of revenues generated by payroll taxes and the income taxation of Social Security benefits. As a result of the lower Social Security benefit, the effect of the reduction from
adow” annuity is to reduce the Social Security benefit to the level where it falls below the poverty threshold for the scaled low-earner, forcing this worker to annuitize a portion of his or her
l individual account balance to reach poverty threshold. These results do not take into account the additional benefit reductions (on top of those due to the benefit offset and reductions to
ve solvency under current law) that would be necessary under the individual account plan in order to achieve solvency under a payable baseline. If additional benefit reductions were required
r the individual account scenario, workers would be required to annuitize a larger portion of their individual accounts to reach the poverty threshold. Thus, these results tend to overstate the
fit levels that would be payable under the President’s IA proposal. Please refer to accompanying memorandum for detailed description of methodology used.