ANALYSIS OF ISSUES
RELATING TO SOCIAL SECURITY
INDIVIDUAL PRIVATE ACCOUNTS
Scheduled for a Public Hearing
Before the
SENATE COMMITTEE ON FINANCE
on March 16, 1999
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
March 15, 1999
JCX-14-99
CONTENTS
A. Social Security
B. Cash or Deferred Arrangements ("Section 401(k) Plans")
C. Federal Thrift Savings Plan
D. Individual Retirement Arrangements ("IRAs")
III. DESIGN AND IMPLEMENTATION ISSUES RELATING TO
INDIVIDUAL ACCOUNTS
A. Overview of Individual Accounts
B. Funding Sources and Allocation of Administrative Costs
C. Administrative Issues Relating to Investments
D. Administrative Issues Relating to Contributions
E. Distributions from Individual Accounts
1. Access to funds prior to retirement
2. Portability of account balances
3. Form of distributions
4. Coordination with Social Security
5. Administrative issues with respect to taxation of distributions
6. Miscellaneous distribution issues
F. Survivor and Spousal Rights
G. Interaction with Employer-Sponsored Retirement Plans
H. Other Administrative Issues
IV. ECONOMIC ISSUES RELATING TO PRIVATE ACCOUNTS
A. Private Account Accumulations and Annuity Values
B. General Economic Issues
1. Overview
2. Impact on national saving
3. Funding and tax treatment of IPAs; coordination of IPAs
with Social Security
4. Account investment issues
V. BACKGROUND INFORMATION RELATING TO RETIREMENT SAVINGS
A. Economic Status of the Elderly
B. Expected Retirement Income and Needs of Current Workers
C. Increases Retirement Costs
A. Developed Countries
1. United Kingdom
2. Australia
3. Sweden
B. Newly Industrialized Countries
1. Chile
2. Mexico
3. Argentina
The Senate Committee on Finance has scheduled a public hearing on March 16, 1999, on issues relating to personal retirement accounts. This document,(1) prepared by the staff of the Joint Committee on Taxation, provides an overview of present-law rules relating to Social Security and certain tax-favored retirement arrangements and discusses issues relating to individual private accounts.
Part I of the document is an overview. Part II provides an overview of the present-law rules relating to Social Security, certain types of employer-sponsored retirement plans, and individual retirement arrangements ("IRAs"). Part III discusses design and implementation issues relating to individual accounts. Part IV discusses economic issues relating to private accounts. Part V provides background information relating to retirement savings, and Part VI provides background information regarding experience in other countries with alternatives to pay-as-you-go financing for social security programs.
Goals of private account proposals
The current interest in a new system of individual private accounts ("IPAs") owes its origin, at least in part, to the long-term funding issues of the current Social Security system. IPAs could be used as an alternative means of funding Social Security by coordinating Social Security benefits with IPA accumulations. IPAs could also be used to increase retirement saving generally (without coordination with Social Security), thereby reducing reliance on Social Security for retirement income. Under this approach, other changes to Social Security funding or benefits would be needed to address the funding issues of Social Security.
Design and implementation issues
IPA proposals raise many administrative issues. A fundamental issue is who will be primarily responsible for IPA administration. Present law provides three basic models for account administration: government-held accounts; accounts based on employer-sponsored section 401(k) plans; and accounts based on individual retirement arrangements ("IRAs"). Regardless of the model adopted, any IPA proposal is likely to involve significantly the Federal Government, as well as possibly employers, financial institutions, and a variety of service providers.
The design and implementation issues raised by any IPA proposal include the following:
Economic issues
IPA proposals also raise a number of economic issues. At the individual level, the key issues concern how the accounts will be funded, how they will be taxed, what level of accumulations could be expected in the accounts at retirement, and what interactions, if any, the accounts will have with Social Security. At the national level, key issues are whether such accounts can be expected to increase national saving and whether they can be expected to provide adequate retirement income (in conjunction with Social Security). The combination of decisions with respect to funding, taxation, and interaction with Social Security will determine the net effect of any IPA proposal on the overall progressivity of the Federal tax and benefit system, as well as on the intergenerational distribution of tax burdens.
Background information relating to retirement savings
Currently, Social Security is the largest source of retirement income (39 percent in 1996), followed by wage and salary income (22 percent in 1996), private and government employee pensions and alimony (18 percent in 1996), and income from assets (17 percent in 1996).
The adequacy of retirement income is commonly measured by the replacement rate, that is, the ratio of retirement income to income during working years. Available data indicate that Social Security and pension benefits replace roughly 33 percent of career high earnings and 50 percent of earnings over the last 5 years of employment for current retirees. When spousal benefits are taken into account, replacement rates are higher. Some recent research has estimated that, for workers retiring over the next 10 years, replacement rates for the median 10 percent of households (45th to 55th percentiles ranked by income) may approach 97 percent in nominal dollars and 66 percent in real (inflation adjusted) dollars. These replacement rates are higher for individuals who had lower earnings.
Although coverage by employer pension plans and Social Security is expected to be higher for current workers than for current retirees, the saving rate of current workers is lower than the rate at which current retirees saved during their working lives. Also, it is possible that the need for retirement income is increasing over time because of increases in life expectancies, trends toward early retirement, and rapid rises in medical costs.
Experience of other countries
A number of other countries have adopted alternatives to pay-as-you-go financing for their social security programs. These include the United Kingdom, Australia, Sweden, Chile, Mexico, and Argentina.
A. Social Security(2)
In general
The Old-Age, Survivors, and Disability Insurance ("OASDI") programs provide monthly benefits to retired and disabled workers, or their dependents and survivors. The primary source of revenue for OASDI is a payroll tax paid by workers covered under the program and their employers. Generally, coverage is compulsory and nearly universal.(3)
Eligibility and participation
Currently, an estimated 96 percent of the Nation's paid work force is covered either voluntarily or mandatorily.
General benefit structure
Insured status
Benefits can be paid to workers, and their dependents or survivors, only if the worker has worked long enough in covered employment to be insured for these benefits. Insured status is measured in terms of "quarters of coverage." Since the beginning of 1978, the crediting of quarters of coverage has been on an annual rather than a quarterly basis up to a maximum of four quarters of coverage per year. The amount of annual earnings needed for a quarter of coverage is increased each year in proportion to increases in average wages in the economy. In 1999, the amount of earnings needed for a quarter of coverage is $740. Therefore $2,960 of wages is necessary to attain four quarters of coverage in 1999.
Under the OASDI program, there are two types of insured status: "fully insured" and "currently insured." Generally, workers are fully insured for benefits for themselves and for their eligible dependents if they have 40 quarters of coverage. If they do not have 40 quarters of coverage, they can still be fully insured if they have a minimum of six quarters of coverage with at least one quarter of coverage for each year after the year they reached age 21 up to the year in which they reach age 62, become disabled, or die. The portion of the requirement for fully-insured status that each worker have a minimum of six quarters of coverage is increased depending on the age of the worker. Fully-insured status is required for eligibility for all types of benefits except certain survivor benefits.
Survivors of a worker who was not fully insured may still be eligible for benefits if the worker was currently insured. For this purpose, a worker is currently insured if the worker has six quarters of coverage during the thirteen calendar quarters ending with the quarter in which the worker died. Survivor benefits are described more fully below.
Workers are insured for disability if they are fully insured and have a total of at least 20 quarters of coverage during the 40-quarter period ending with the quarter in which they became disabled. Workers who are disabled before age 31 are insured for disability if they have total quarters of coverage equal to the greater of six quarters of coverage or quarters of coverage equal to one-half the calendar quarters which have elapsed since the worker reached age 21, ending in the quarter in which they became disabled.
Benefits in general
All monthly benefits are computed based on a worker's primary insurance amount ("PIA"). The PIA is a monthly amount based on the application of the Social Security benefit formula to a worker's average lifetime covered earnings. It is also the monthly benefit amount payable to a worker who retires at the full retirement age, or becomes entitled to disability benefits.
Full retirement age
Benefits for retired workers, aged spouses, and surviving spouses taken before the "full retirement age" are subject to an actuarial reduction. The full retirement age is the earliest age at which unreduced retirement benefits can be received. The full retirement age currently is age 65, but it will gradually rise in two steps beginning in the year 2000. First, the full retirement age will increase by two months for each year that a person is born after 1937, until it reaches age 66 for those who were born in 1943. Second, it will increase again by two months for each year that a person is born after 1954, until it reaches age 67 for those who were born after 1959. Early retirement still will be available, beginning at age 62 for workers and their spouses, and at age 60 for widow(er)s, but benefits will be lower. The actuarial reduction on retirement benefits at age 62 ultimately will be 30 percent, instead of the present 20 percent. The age for full benefits for aged spouses and surviving spouses likewise will rise to 67.
Benefits of workers who choose to retire after their full retirement age are increased by delayed retirement credits, as are the benefits payable to their surviving spouses. The delayed retirement credit is one percent per year for workers who attained age 65 before 1982, and one percent per year for workers who attained age 65 between 1982 and 1989. Starting in 1990, the delayed retirement credit increases by one-half of one percent every other year until it reaches eight percent for workers reaching age 65 after 2007.
Benefit formula
Except for workers who are eligible for a "special minimum benefit," the PIA is determined through a formula applied to the worker's average indexed monthly earnings ("AIME"). The AIME is a dollar amount that represents the average monthly earnings from Social Security-covered employment over most of the worker's adult life indexed to the increase in average annual wages. For a worker becoming eligible in 1999, the PIA is 90 percent of the first $505 of AIME, plus 32 percent of $505 through $3,043 of AIME, plus 15 percent of AIME over $3,043.
Special minimum benefit
The special minimum benefit is not based on the amount of the worker's AIME, but instead on the worker's number of years of covered employment. It is structured to provide a larger benefit than would otherwise be payable to those who worked in covered employment for many years but had low earnings. The special minimum benefit in 1999 ranges from $27.90 per month for workers with 11 years of covered wages to $567.00 per month for workers with at least 30 years of covered wages.
Earnings limit
Senior citizens age 70 and older, and disabled individuals, regardless of age, are eligible to receive full Social Security benefits regardless of the amount of earnings they have from wages or self-employment. Those between the full retirement age (currently age 65) and age 70 receive full benefits only if their earnings are lower than an earnings limit amount determined by law. Those below full retirement age have a separate earnings limit. In 1999, the earnings limit for those below the full retirement age is $9,600. The earnings limit is indexed to the rise of average wages in the economy. Those below full retirement age (currently, age 65) lose $1 of benefits for every $2 in wages or self-employment income they earn over the limit. In 1999, the limit for those age 65 to 69 is $15,500. This earnings limit will increase to $17,000 in 2000, $25,000 in 2001 and $30,000 in 2002. Senior citizens between the age of full retirement (currently age 65) and 70 who earn more than the earnings limit lose $1 in benefits for every $3 in wages or self-employment income they earn over the limit.
Funding and contributions
Financing mechanism
The primary source of revenue for the OASDI program is the payroll tax paid by workers covered by the program and their employers. Coverage under Social Security is generally compulsory.
The taxes for wage and salaried workers are imposed under the Federal Insurance Contributions Act ("FICA," chapter 21 of the Internal Revenue Code). Taxes are based on earnings up to the annual maximum taxable wage base ($72,600 in 1999 for OASDI).(4) The employee share of the OASDI payroll tax is withheld from wage and salary payments, and is matched by employers. The current rate for employers and employees is 6.2 percent each for a combined FICA tax rate of 12.40 percent.(5) Self-employed individuals are covered by the Self-Employment Contributions Act ("SECA," chapter two of the Internal Revenue Code). Such individuals pay contributions on their net earnings annually up to the same maximum as employees, but at a rate that is equal to the combined employee-employer tax rate. However, the self-employed are allowed a deduction from their net earnings in computing their Social Security tax(6) and may also deduct half of their Social Security tax as a business expense for income tax purposes. These deductions have the effect of equalizing the payroll tax burden between wage and salaried workers and the self-employed.
Tax liability under the OASI and DI portion of the tax is credited to the Old-Age and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund, respectively.(7) In addition, the income tax liability attributable to the taxation of Social Security benefits is credited to the respective trust funds (for additional detail, see section on "Tax Treatment of Social Security benefits," below). The trust funds are the source of payment for: (1) monthly benefits when the worker retires, becomes totally disabled, or dies and (2) administrative expenses for the program.
Investments
Social Security taxes flow into the U.S. Treasury, through depository accounts maintained by the government in financial institutions across the country, with each program's share credited to separate trust funds (one for OASI, another for DI). The crediting occurs through the posting of interest bearing Federal securities in the appropriate fund (the interest rate is the same as the average rate prevailing on outstanding Federal bonds with a maturity of four years or longer). These securities enjoy the full faith and credit of the United States Government as do any other Treasury bond. When the government makes payments of Social Security benefits, it posts a reduction in the appropriate fund. These Social Security benefit checks are paid from the U.S. Treasury. Currently, there are no other investment options allowed for Social Security taxes.
Distributions
As described in detail above, Social Security provides benefits only at retirement, death or "disability." Further, the program does not provide any mechanism for workers or their families to borrow against future benefits. Benefits are paid monthly. Retirement, disability and other benefits for a surviving spouse are generally payable for the participants lifetime.
Disability, spousal and survivor benefits
Dependents' benefits are payable in addition to benefits payable to the worker. Individuals eligible for both these dependents' benefits and benefits under their own work history would receive the greater of the two benefits.
Disability benefits
Disability benefits are computed as if the worker reached full retirement age on the day the worker became totally disabled (i.e., using 100 percent of the worker's PIA). Generally, disability is defined as the inability to engage in "substantial gainful activity" by reason of a physical or mental impairment. There are also special definition and eligibility requirements for persons who are blind. There is no minimum age requirement for disability benefits.
Spouse's benefits
A benefit is payable to a spouse of a retired or disabled worker under one of the following conditions: (1) the spouse and the worker are currently married and the spouse is at least 62 or is caring for one or more of the worker's entitled children who are disabled or have not reached age 16; or (2) a divorced spouse is at least 62, is not married, and the marriage had lasted at least 10 years before the divorce became final. Subject to the maximum family benefit limitation and reduction for early retirement, the spouse's benefit is limited to 50 percent of the PIA. A divorced spouse may be entitled independently of the worker's retirement to benefits, if both the worker and divorced spouse are age 62, and if the divorce has been final for at least two years.
Survivor's benefits
Surviving spouse's benefit.--A monthly survivor benefit is payable to a surviving or divorced spouse of a worker who was fully insured at the time of death. The surviving or divorced spouse must be unmarried (unless the remarriage occurred after the surviving spouse first became eligible for benefits as a surviving spouse); and must be either (1) age 60 or older or (2) age 50-59 and disabled.
Child's benefit.--A monthly benefit is payable to certain unmarried dependents, (i.e., a biological or adopted child, stepchild, and grandchild) of a retired, disabled, or deceased worker who was fully or currently insured at death. Dependency is deemed for the insured's biological children and most adopted children. The child must be either: (1) under age 18; (2) a full-time elementary or secondary student under age 19; or (3) a disabled person age 18 or over whose disability began before age 22.
Surviving parent's benefit.--A monthly survivor benefit is payable to a surviving parent, whether or not divorced from the deceased worker, if: (1) the deceased worker on whose account the benefit is payable was fully or currently insured at time of death; and (2) the surviving parent is not married and has one or more entitled children of the deceased worker in his or her care. In the case of a surviving divorced mother or father, the child must also be the applicant's natural or legally adopted child. These payments continue as long as the youngest child being cared for is under age 16 or disabled.
Parent's benefit.--A monthly survivor benefit is payable to a parent of a deceased fully-insured worker who is age 62 or over, and has not married since the worker's death. The parent must have been receiving at least one-half of her support from the worker at the time of the worker's death or, if the worker had a period of disability which continued until death, at the beginning of the period of disability.
Percentage of PIA used in calculating survivor's benefits.--Subject to the maximum family benefit limitation and reduction for early retirement, the following survivor's benefits are generally limited to: (1) 100 percent (75 percent if age 62 but not age 65) of the PIA for widow(er)s age 65; (2) 75 percent of the PIA for children, mothers, and fathers; and (3) 82.5 percent of the PIA for a dependent parent aged 62 or more.
Lump-sum death benefit.--A one-time lump-sum benefit of $255 is payable upon the death of a fully or currently-insured worker to the surviving spouse who was living with the deceased worker or was eligible to receive monthly cash survivor benefits upon the worker's death. If there is no eligible spouse, the lump-sum death benefit is payable to any child of the deceased worker who is eligible to receive monthly cash benefits as a surviving child. If there is no surviving spouse, or children of the worker eligible for monthly benefits, then the lump-sum death benefit is not paid.
Maximum family benefit.--The maximum monthly amount that can be paid on a worker's earnings record varies with the PIA. For benefits payable on the earnings records of retired or deceased workers, the maximum varies from 150 to 188 percent of the PIA. The family maximum cannot be exceeded regardless of the number of recipients entitled on that earnings record.
Miscellaneous administrative issues
The cost of administering the Social Security programs are financed from the Social Security Trust Funds, subject to annual appropriations. Traditionally, these costs comprise less than one percent of annual benefit payments.
Tax treatment of Social Security benefits
Taxpayers receiving Social Security benefits are required to include portion of such benefits in gross income if their "provisional income" exceeds $25,000, in the their case of unmarried taxpayers, or $32,000, in the case of married taxpayers filing joint returns. For purposes of these computations, a taxpayer's provisional income is defined as adjusted gross income ("AGI") plus: (1) tax-exempt interest; (2) certain amounts excluded under adoption assistance programs and educational savings bonds; (3) the deduction for qualified student loan interest; (4) certain foreign source income; and (5) one-half of the taxpayer's Social Security benefit. A second-tier threshold for provisional income is $34,000, in the case of unmarried taxpayers, or $44,000, in the case of married taxpayers filing joint returns.
If the taxpayer's provisional income exceeds the lower threshold but does not exceed the second-tier threshold, then the amount required to be included in income is the lesser of (1) 50 percent of the taxpayer's Social Security benefit, or (2) 50 percent of the excess of the taxpayer's provisional income over the lower threshold.
If the amount of provisional income exceeds the second-tier threshold, then the amount required to be included in income is the lesser of: (1) 85 percent of the taxpayer's Social Security benefit; or (2) the sum of (a) 85 percent of the excess of the taxpayer's provisional income over the second-tier threshold, plus, (b) the smaller of (i) the amount of benefits that would have been included if the 50-percent inclusion rule (the rule in the previous paragraph) were applied, or (ii) one-half of the difference between the taxpayer's second-tier threshold and lower threshold.
As noted above, the revenue derived from the income taxation of a portion of Social Security benefits is credited to the Social Security trust funds.
B. Cash or Deferred Arrangements
("Section 401(k) Plans")
In general
A qualified cash or deferred arrangement is a type of tax-qualified employer-sponsored retirement plan.(8) Cash or deferred arrangements are called section 401(k) plans after the section of the Internal Revenue Code (the "Code") governing such arrangements. The distinguishing feature of a section 401(k) plan is that employees can elect to make pre-tax contributions to the plan in lieu of receiving cash compensation. Contributions made at the election of the employee are referred to as elective deferrals. For Federal tax purposes, employee elective deferrals are generally treated as employer contributions.
Like all qualified retirement plans, section 401(k) plans receive favorable tax treatment. Employer contributions to the plan (including elective deferrals) are currently deductible; however, employees are not taxed on plan benefits until received. In exchange for favorable tax treatment, section 401(k) plans are subject to a variety of rules.(9) Many of these rules apply to qualified plans generally; while some rules apply only to section 401(k) plans.
Eligibility for participation
Subject to certain restrictions, the employer decides who is eligible to participate in a qualified plan. Thus, subject to those restrictions, an employer can limit 401(k) participation in a qualified plan to certain groups or classifications of employees.
Under the Federal tax laws, a section 401(k) plan may not require that an individual complete more than one year of service before being eligible to participate in a section 401(k) plan. In addition, a qualified plan cannot require that an individual be older than age 21 in order to participate.
Section 401(k) plans, like all qualified retirement plans, are subject to nondiscrimination and coverage rules designed to ensure that the plan benefits a broad cross-section of employees, not just the employer's highly compensated employees. These rules may operate to restrict the participation choices of the employer. For example, if an employer restricts participation in a qualified plan only to top executives, the plan would likely fail the coverage and nondiscrimination tests.
General benefit structure
Section 401(k) plans are a type of defined contribution plan. Under a defined contribution plan, a participant's benefit is the participant's account balance. That is, the benefit is equal to contributions, as adjusted by investment gains and losses. The participant bears the risk of investment losses.
Funding and contributions
There are four types of contributions that may be made to a section 401(k) plan. First, employees may make elective deferrals. Second, the employer may make matching contributions to the plan based on the employees' elective deferrals. For example, an employer might match 50 percent of employee elective deferrals up to 3 percent of compensation. Third, the employer may make nonelective employer contributions, i.e., employer contributions that are not dependent on the elective deferrals made by employees. Finally, employees may make after-tax contributions to the plan. Each of these types of contributions are subject to certain limits under the Code. Subject to these limits, the plan provisions specify the kind and level of permitted contributions.
The maximum amount of elective deferrals that can be made by an employee to a section 401(k) plan for a year is $10,000 (for 1999). Elective deferrals are subject to a special nondiscrimination test that limits the deferrals that can be made by highly compensated employees by the amount of deferrals made by nonhighly compensated employees. This
nondiscrimination test, and the dollar limit on elective deferrals, may limit contributions that would otherwise be made to the plan, particularly by highly compensated employees. Matching contributions that meet certain requirements and nonelective contributions may be taken into account in applying the special nondiscrimination test for section 401(k) plans. Some employers make matching contributions in order to make the plan more attractive, even if the contributions are not taken into account in applying the special nondiscrimination test.(10)
Matching contributions and employer nonelective contributions are not subject to a specific dollar limit. However, there is an overall limit on the annual additions that can be made to an employer's plans on behalf of an employee. This limit is the lesser of 25 percent of compensation or $30,000. Matching contributions, employer nonelective contributions, as well as employee elective deferrals are taken into account in applying this limit. Limits on the amount an employer can deduct for contributions to a qualified plan may also limit the contributions made to the plan.
Employee elective deferrals must be 100 percent vested. If employer matching and nonelective contributions are taken into account in applying the special nondiscrimination test for section 401(k) plans, then they must be 100 percent vested. Otherwise, such contributions must vest at least as rapidly as under one of two vesting schedules applicable to qualified plans generally.(11)
All qualified plan assets must be held in trust for the exclusive benefit of participants and their beneficiaries. Under Department of Labor regulations, elective deferrals generally must be held in trust no later than 15 business days after the end of the month in which the contributions are received by the employer or would have been paid to the employee in cash if not withheld from wages.
Investments
In general
In general, account balances in a section 401(k) plan can be invested in one of three ways: (1) by a plan fiduciary; (2) pursuant to participant direction; or (3) as directed by the plan document. It is common for section 401(k) plans to provide at least some participant-directed investment. The same investment method need not be used for all contributions. For example, a plan could provide that participants can direct the investment of their elective deferrals, but not matching contributions.
Investment by plan fiduciary
Plan assets may be invested by a plan fiduciary. In general, Federal law does not restrict the types of investments that can be made by a plan, but rather imposes a general fiduciary duty. Under ERISA, plan fiduciaries are required to discharge their duties (1) solely in the interest of plan participants and beneficiaries, (2) for the exclusive purpose of providing benefits and defraying reasonable administrative expenses, (3) with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise with like character and like aims, (4) by diversifying investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so, and (5) in accordance with the instruments governing the plan insofar as such instruments are consistent with ERISA.
In addition to the general fiduciary standard, ERISA and the Code prohibit certain transactions between a plan and certain parties closely associated with a plan.
Plan fiduciaries are liable to the plan for any investment losses as a result of a breach of fiduciary duty.
Participant-directed investments
Although plans can give participants complete investment discretion, it is more common for plans to provide a limited range of alternatives with varying degrees of risk and possible returns. Permitting total investment discretion typically involves greater administrative costs, as well as a high degree of investment experience on the part of plan participants.
If a participant has complete control over investments, then plan fiduciaries cannot be held liable for losses resulting from the exercise of that control. In addition, if certain requirements are satisfied, then plan fiduciaries are not liable for losses resulting from more limited participant control over investments. In order for this exception from the fiduciary rules to apply, among other things, the plan must offer at least 3 investment alternatives that together offer a broad array of investment alternatives.
Plans that permit participant directed investments must adopt rules that deal with various issues such as a default investment in case the participant fails to make an investment election and how to make changes in investments.
Investment pursuant to plan provisions
Plans will sometimes provide that certain funds are to be invested in certain assets, typically securities of the employer adopting the plan.
Administrative costs
Section 401(k) plans have a variety of administrative costs, including investment fees, fees relating to the sending of notices, trustee fees, employee communication fees and other fees associated with the adoption and operation of a plan. Plan fees generally can be paid directly by the employer, or by the plan and allocated among plan participants. Most section 401(k) plans charge at least a portion of administrative expenses to plan participants.
Distributions
Timing of distributions
All qualified plans, including section 401(k) plans, must provide that, unless the participant elects otherwise, benefit payments under the plan will begin no later than 60 days after the plan year in which the last of the following occurs: (1) the participant attains the earlier of age 65 or the normal retirement age specified under the plan; (2) the participant's 10th anniversary of plan participation; or (3) termination of service with the employer. This rule ensures that plans cannot indefinitely defer the commencement of benefits beyond retirement age. Section 401(k) plans typically provide for payment of benefits upon separation from service.
Qualified plans, including section 401(k) plans, also cannot cash out benefits without the participant's consent if the participant's benefit exceeds $5,000. This rule is designed to help keep retirement benefits in a tax-favored retirement vehicle until needed for retirement.
Section 401(k) plans are also subject to certain rules designed to help ensure that plan benefits are available for retirement purposes. Thus, distributions of amounts attributable to employee elective deferrals cannot be distributed earlier than (1) separation from service, death or disability, (2) the attainment of age 59-1/2, or (3) hardship.(12)
While section 401(k) plans do not have to provide for in-service distributions (i.e., distributions before retirement, separation from service, death or disability), it is common for such plans to allow for hardship withdrawals. Under present law, in general, a distribution is made on account of hardship only if it is made on account of an immediate and heavy financial need and is necessary to satisfy the financial need. A distribution is deemed to be on account of a heavy and immediate financial need if the distribution is for the purchase a principle residence (excluding mortgage payments), payment of education expenses, medical expenses, or to prevent eviction. The ability to make hardship withdrawals is an attractive plan feature to plan participants, even if they never take a hardship withdrawal. Allowing such withdrawals imposes
administrative burdens on the plan, which must ensure that the distribution satisfies the criteria for a hardship withdrawal.
Present law requires that minimum distributions from all qualified plans, including section 401(k) plans, generally must begin by the later of (1) retirement or (2) attainment of age 70-1/2. This rule reflects the idea that qualified plans are intended to provide for retirement income, not deferral of income beyond retirement.
Form of distributions
Section 401(k) plans are not required to provide for distributions in any particular form. Plans typically offer a lump-sum option, and may also provide for payments over a period of years, such as over the life expectancy of the participant and his or her beneficiary. Plans typically limit the distribution options in order to minimize administrative burdens. Most section 401(k) plans do not offer annuity options because of the increased administrative burdens associated with annuities. For example, plans that offer an annuity are subject to joint and survivor requirements described below. Individuals who want to defer payment of benefits beyond the period provided by the plan can take a lump-sum distribution and roll the distribution over into an IRA. Distributions from the IRA then can be taken over a period of years.
Loans
Qualified plans may permit individuals to obtain a loan from the plan, provided certain requirements are made with regard to the amount of the loan and repayment terms. In addition, such loans must bear a reasonable rate of interest and be adequately secured; the account balance is frequently used as security for the loan. If the participant does not repay the loan (i.e., defaults) then the amount of the unpaid loan is deducted from the participant's account balance. Many section 401(k) plans offer loans, sometimes in addition to hardship withdrawals.
Taxation of distributions
Distributions from section 401(k) plans are includible in income in the year received. In addition, distributions prior to attainment of age 59-1/2, death or disability are subject to an additional 10-percent early withdrawal tax, unless an exception to the tax applies. Exceptions to the tax applicable to section 401(k) plans include certain periodic distributions, distributions upon separation from service after age 55, and distributions for medical expenses in excess of 7.5 percent of adjusted gross income.
Distributions from section 401(k) plans (other than certain periodic distributions) can be rolled over tax free to an IRA (other than a Roth IRA).
Survivor, disability and spousal benefits
Disability benefits
Section 401(k) plans typically do not provide a special disability benefit. However, disability is generally an event that allows the participant to obtain distributions from the plan.
Survivor and spousal benefits
The spousal benefits that must be provided under a section 401(k) plan depend on whether or not the plan offers an annuity as a form of benefit. If the plan offers an annuity and the participant elects the annuity option, then benefits must be paid in the form of a qualified joint and survivor annuity that provides a survivor annuity to the participant's spouse, unless the participant and his or her spouse elect otherwise. A qualified joint and survivor annuity pays an annuity for the life of the participant, with a survivor annuity which is not less than 50 percent (and not more than 100 percent) of the amount of the annuity payable during the joint lives of the participant and his or her spouse. If the plan does not offer an annuity (or the participant does not elect the annuity option), the spousal rights are more limited; in such cases the spouse must be the participant's beneficiary, unless the spouse consents to another beneficiary. Most section 401(k) plans do not offer an annuity as a form of benefit because doing so increases plan administrative responsibilities.
Unless a section 401(k) plan offers an annuity, there is no specified death benefit. Rather, the participant's beneficiary is entitled to the remaining account balance upon the participant's death.
Section 401(k) plan benefits, like other qualified plan benefits, are subject to division upon divorce or separation.
Enforcement
There are a variety of ways in which the rules applicable to section 401(k) plans can be enforced, both under the Internal Revenue Code and ERISA. In general, the sanction for failure to meet the requirements applicable to all qualified retirement plans is plan disqualification. However, disqualification is a harsh sanction that can adversely affect plan participants. In most cases, the Internal Revenue Service utilizes administrative remedies in lieu of disqualification that attempt to correct the error involved.
Some rules relating to qualified plans are enforced through tax sanctions other than disqualification. For example, a 15-percent excise tax is imposed on prohibited transactions between a qualified plan and certain persons. The excise tax increases to 100 percent if the transaction is not corrected within a certain period.
ERISA permits participants, plan fiduciaries and the Department of Labor to bring suit to enforce ERISA's various requirements. In some cases, criminal penalties apply.
In addition, under ERISA, all tax-qualified plans are required to include a claims procedure pursuant to which a participant or beneficiary can challenge a denial of benefits under the plan. The claims procedure must afford a reasonable opportunity for a full and fair review by the appropriate plan fiduciary.
Miscellaneous administrative issues
Both the Code and ERISA contain a variety of other administrative rules that must be complied with. For example, certain reporting and disclosure rules apply.
C. Federal Thrift Savings Plan(13)
In general
The Thrift Savings Plan ("TSP") is a section 401(k) plan for Federal employees. The TSP is generally subject to the same rules that apply to section 401(k) plans of private employers. The TSP is sometimes used as a model for section 401(k) plans. The TSP was designed primarily for Federal employees who are participants in the Federal Employees' Retirement System ("FERS") to supplement the FERS basic annuity benefit.
Eligibility for participation
Certain groups of Federal employees are eligible to participate in the TSP.
General benefit structure
Like all defined contribution plans, the participant's benefit under the TSP is equal to the participant's account balance.
Funding and contributions
The contribution levels for Federal employees varies based on the agency employing the employee and the retirement system covering the employee. All FERS employees may contribute either a percentage of basic pay each pay period or a fixed dollar amount to the TSP, subject to the elective deferral limit under the Federal tax laws. If the employee does contribute to the TSP, the employee may receive agency matching contributions on employee contributions of up to four percent of basic pay each pay period. The match is dollar for dollar on the first three percent of pay contributed by the employee and 50 cents on the dollar on the next two percent. The Federal Government also makes a one percent nonelective contribution to the TSP for all FERS employees, whether or not the employee makes a separate elective deferral contribution.
Investments
Each TSP participant may choose to invest any part of his or her account in the three TSP investment funds: (1) the government securities investment fund (the "G fund"); (2) the common stock index investment fund (the "C fund"); or (3) the fixed income index investment fund (the "F fund").(14) The TSP allows for investment in one or more of the funds as a part of the worker's regular contributions. It also allows the worker to move existing fund balances in an interfund transfer during two open seasons held each year.
The G fund is managed by the Federal Retirement Thrift Investment Board (the "Board"). Its assets are held in trust in the U.S. Treasury. The G fund consists almost exclusively of investments in short-term non-marketable U.S. Treasury securities specially issued to the TSP.
The C fund is managed by Barclay's Global Investors, which holds the assets in trust and acts as the investment manager. The C fund is invested primarily in the Barclay's Equity Index Fund, a commingled stock index fund that tracks the Standard & Poors 500 ("S&P 500") stock index.
The F fund also is managed by Barclay's Global Investors. The F fund is invested primarily in the Barclay's U.S. Debt Index Fund, a commingled bond index fund designed to track, as closely as possible, the Lehman Brothers Aggregate ("LBA") index. The LBA represents the U.S. Government, corporate and mortgage-backed securities sectors of the fixed-income securities market.
Distributions
A withdrawal from the TSP generally may not be made until the worker has separated from Federal service. An exception is made for certain financial hardships. The worker can have the payments begin immediately or at a later date, but tax penalties may apply if the worker separates from employment or retires before the year in which he turns 55 and withdraws funds before age 59-1/2. The TSP provides three basic ways to withdraw from the worker's account.(15) The three options are to:
(1) receive a single payment equal to the balance in the worker's TSP account;
(2) receive the account balance in a series of monthly payments. Options include payments for a fixed number of months, monthly payments for a fixed dollar amount until the account is depleted, or monthly payments based on the IRS life expectancy table; or
(3) have the TSP purchase a life annuity.
Generally, the TSP provides funds only at retirement or death with no special provision for disability benefits. The TSP allows for hardship withdrawals which are taxable, and may be subject to early withdrawal penalties. A participant who receives a hardship withdrawal is prohibited from contributing to the TSP for six months.
The TSP also has a mechanism for workers to borrow against future benefits. The borrower must be working at the time of repayment, because repayments are made through payroll allotments. There are two types of loans: (1) general purpose loans from the worker's contributions and earnings, with a repayment period of one to four years; and (2) residential loans for the purchase of a principal residence, with a repayment period of one to fifteen years.
Survivor, disability and spousal benefits
Survivor and spousal benefits.--Generally, if the worker dies with an outstanding balance in his or her TSP account, the balance is distributed according to the most recent, valid designation-of-beneficiary form. If the individual was married at the time of death, the account is generally paid to the surviving spouse unless the surviving spouse had previously agreed to have a different beneficiary named. If death occurs after the TSP has purchased an annuity, benefits are provided according to the annuity option selected. TSP benefits are subject to division upon divorce or separation.
Disability benefits.--The TSP does not provide additional benefits in the case of a disability. However, disability is an event that allows participants to obtain distributions from the plan.
Withdrawals.--If the TSP participant is married, then benefits will be paid in the form of a joint and survivor annuity unless the participant and the participant's spouse consent to another form of payment.
Miscellaneous administrative issues
The Federal Retirement Thrift Investment Board administers the TSP and contracts with a separate organization to serve as a TSP record keeper. Currently, the Board has an agreement with the U.S. Department of Agriculture's Nation Finance Center ("NFC") to provide record keeping services for the TSP. The NFC maintains the accounts of TSP participants and processes withdrawals, loans, interfund transfers, and participants designation of beneficiaries. The worker's employing agency distributes TSP materials and answers questions about the TSP.
Tax treatment of TSP
TSP contributions and earnings are subject to the same tax rules as section 401(k) plans.
In general
An individual retirement arrangement ("IRA") is a tax-favored savings vehicle available to individuals.(16) Under present law, there are three different types of IRAs-deductible IRAs, Roth IRAs, and nondeductible IRAs-each of which are subject to somewhat different tax rules. Contributions to a deductible IRA are deductible, earnings are not currently taxable, and amounts withdrawn from a deductible IRA are includible in income when withdrawn. Contributions to a nondeductible IRA are not deductible, earnings on amounts in a nondeductible IRA are not currently taxable, and amounts withdrawn from a nondeductible IRA are includible in income in the year withdrawn to the extent attributable to earnings. Contributions to a Roth IRA are not deductible and earnings are not currently taxable. If certain requirements are satisfied, distributions from a Roth IRA are not includible in income.
Although the tax rules applicable to the various types of IRAs are different, the administration of all types of IRAs is similar. IRA assets are held by banks or similar financial institutions. In general, the individual IRA owner is responsible for complying with the rules applicable to IRAs.
Eligibility for participation
Deductible IRAs
The ability to make deductible contributions to an IRA depends on the income of the individual and whether or not the individual and his or her spouse is an active participant in an employer-sponsored retirement plan.
If an individual (and his or her spouse, if any) is not an active participant in an employer-sponsored retirement plan, then the individual may make the maximum permitted IRA contribution. If the individual is not an active participant, but the individual's spouse is, then the maximum contribution is phased out between adjusted gross income ("AGI") of $150,000 to $160,000.
If the individual is an active participant in an employer-sponsored retirement plan, then the maximum contribution is phased out between AGI of $51,000 to $61,000 (for 1999) for married taxpayers filing a joint return and $31,000 to $41,000 (for 1999) for single taxpayers.(17)
Roth IRAs
The maximum annual contribution that can be made to a Roth IRA is phased out for single individuals with AGI between $95,000 and $110,000, and for married taxpayers filing a joint return with AGI between $150,000 and $160,000.
Nondeductible IRAs
There are no income limits on nondeductible IRAs; any individual with earned income can contribute to a nondeductible IRA.
General benefit structure
An IRA is similar to a tax-qualified defined contribution plan. That is, the amount payable from an IRA is the account balance. The individual bears the risk of investment losses.
Funding and contributions
The maximum amount that can be contributed to all an individual's IRAs in a year is the lesser of $2,000 or the individual's earned income. In the case of a married couple, a contribution of up to $2,000 can be made for each spouse as long as the couple has earned income of at least the contributed amount.
Contributions to an IRA may be made until April 15th of the year following the year for which the contribution is being made.
The individual making the contribution to an IRA must determine the maximum contribution the individual is eligible to make.
In order to help enforce the $2,000 annual contribution limit, an IRA cannot accept a contribution (other than a contribution rolled over from another IRA or plan) in excess of $2,000. In addition, excess contributions are subject to an excise tax if not withdrawn from the IRA.
Investments
In general, IRAs can be invested in whatever investment vehicles the IRA provider makes available. The individual IRA owner chooses the investments he or she wants to make. Financial institutions generally charge fees relating to IRA maintenance and investment.
IRAs may not invest in life insurance or collectibles. In addition, IRA assets may not be pledged as security as a loan. IRAs are also subject to the same prohibited transaction rules applicable to qualified plans. Thus, IRA assets generally cannot be invested in a transaction in which the IRA owner has an interest. For example, IRA funds could not be used to make the down payment on a home in which the owner was living.
Distributions
Timing of distributions
The minimum distribution rules generally apply to IRAs (other than Roth IRAs). Thus, distributions from an IRA must begin at age 70-1/2. Post-death minimum distribution rules apply to all IRAs, including Roth IRAs.
There are no distribution restrictions applicable to IRAs. Thus, amounts can be withdrawn from an IRA at any time. However, early distributions are subject to the 10-percent early withdrawal tax, unless an exception applies In addition, the tax consequences of a withdrawal from a Roth IRA may be affected if a distribution is made before the requirements for tax-free withdrawal have been satisfied.
Form of distributions
Subject to the minimum distribution rules, individuals may withdraw funds over any time period they desire. If an individual wishes to annuitize benefits, they could use an IRA assets to purchase an annuity.(18)
Taxation of distributions
Distributions from a deductible IRA are fully includible in income. Distributions from nondeductible IRA are includible in income to the extent attributable to earnings. In general, each distribution from a nondeductible IRA is treated in part as a return of contributions and in part as taxable earnings.
Distributions from a Roth IRA are tax free if certain requirements are satisfied. If a distribution from a Roth IRA is taxable, then only the amount of the distribution attributable to earnings is includible from income. In general, distributions from Roth IRAs are treated as coming first from contributions.
Taxable distributions from an IRA prior to age 59-1/2 are subject to an additional 10-percent early withdrawal tax. Exceptions to the tax apply to certain periodic distributions, distributions for medical expenses in excess of 7.5 percent of adjusted gross income, distributions for health insurance expenses of unemployed individuals, education expenses, and first-time homebuyer expenses.
Survivor, disability, and spousal benefits
IRA owners can designate a beneficiary or beneficiaries that will be entitled to receive the remaining interest in the IRA upon the death of the IRA owner. If the beneficiary is the surviving spouse, he or she can treat the IRA as his or her own.
IRAs are not subject to the spousal rules applicable to qualified plans. Thus, the IRA owner may name whoever he or she chooses as the beneficiary.
IRAs are subject to division upon divorce or separation.
Enforcement
The instrument creating an IRA is required to include certain of the rules applicable to IRAs. In addition, the financial institution responsible for the IRA is subject to certain reporting requirements.
In general, however, the individual IRA owner is responsible for making sure that contributions to an IRA are made in accordance with the applicable rules and that the tax rules are applied appropriately. An individual who is audited may be required to demonstrate that her or she was in fact entitled to the tax treatment claimed with respect to the IRA, e.g., that a IRA deduction was properly taken or that a distribution was not subject to the early withdrawal tax because of applicable of an exception to the tax.
III. DESIGN AND IMPLEMENTATION ISSUES RELATING
TO INDIVIDUAL ACCOUNTS
A. Overview of Individual Accounts
The current interest in a new system of individual private savings accounts owes it origin, at least in part, to the long-term funding issues of the current Social Security system. Individual private accounts ("IPAs") could be used to improve the long-term financial status of the Social Security system by providing an alternative to the current method of funding Social Security benefits. This would be accomplished by coordinating the benefits an individual receives under Social Security with the amounts accumulated in the individual's IPA. IPAs could also be used as a means to increase the retirement savings of individuals generally (without coordinating with Social Security), which could reduce reliance of individuals on the Social Security system as a primary source of retirement income. This reduced reliance on the Social Security system would take some pressure off of the system and reduce the relevance of the long-term financial problems of the system. However, under this approach, other changes to Social Security benefits or funding would be needed to impact the financial status of the Social Security system.
Certain fundamental structural issues must be addressed in the development of an IPA system. These issues include the following:
(1) Is the IPA system intended as an independent add-on to the Social Security system or it is intended to partially or fully replace the Social Security system?
(2) Is participation in a system of IPAs voluntary or mandatory?
(3) Is participation in a system of IPAs limited to wage earners or are all individuals (or all taxpayers) entitled or required to participate?
Decisions with respect to these issues have significant policy and administrative implications. Because such decisions will likely be made in the context of a broader review of the Social Security system, the issues surrounding such decisions generally are not specifically addressed in the analysis that follows. For purposes of the discussion in this document, it is generally assumed that any new IPA system will have certain features in common with Social Security; in particular, it is assumed that the system will include mandatory contributions and that the system will be limited to workers. It is also generally assumed that IPAs will be coordinated formally with Social Security benefits, e.g., through a reduction in otherwise payable Social Security benefits.
A fundamental issue that must be addressed in deciding how to implement any IPA proposal is who will be primarily responsible for administration of the IPAs. Present law provides three basic models for IPA administration: (1) a system of accounts held and administered by the Federal Government, which would place most of the administrative responsibility of IPAs on the Federal Government; (2) a system of accounts based on the current system of employer-sponsored section 401(k) plans, which would place more responsibility on employers; and (3) a system of accounts based on present-law IRAs, which would place more responsibility on individuals and financial institutions. Regardless of which basic model is chosen, any IPA proposal is likely to require significant involvement of the Federal Government, and, potentially, of employers, individuals, financial institutions, and a variety of service providers.
Implementation of any IPA proposal also raises a number of other administrative issues. These issues are discussed in detail below.
B. Funding Sources and Allocation of Administrative Costs
Funding sources
Contributions to IPAs could be funded in a variety of different ways. A number of proposals contemplate that IPAs will be funded from the current projected budget surpluses. In addition, contributions could be funded through a portion of the current payroll tax or through new taxes. Some proposals describe a funding mechanism whereby individuals would be given what is called a "tax credit," but the amount of the credit would have to be contributed to an IPA. While the descriptions of these various funding sources differ, they may have similar economic implications. The economic effects of IPA funding are discussed in Part IV.B.3., below.
Allocation of administrative costs
The creation and administration of IPAs will generate a variety of administrative costs. These include costs involved in the initial design of the program, start-up expenses (e.g., modifications to existing systems or creation of new systems to collect contributions), ongoing operational expenses (such as expenses for processing distributions, providing notices to employees, employee education, and record keeping), and investment-related expenses. Decisions about design features and how to implement an IPA proposal can impact the level of administrative costs associated with the proposal.
Policy makers will need to decide who will bear the burden of administrative expenses. The experience under employer-sponsored retirement plans may provide some guidance. Under such plans, some expenses, such as those associated with plan design and start up, are typically paid for by the employer. Other expenses may be paid out of plan assets and allocated among all plan participants or allocated to certain plan participants. For example, the costs of changing investments may in some cases be allocated to participants who make such changes.
Similarly, under an IPA proposal, different sorts of administrative costs could be paid in different ways. For example, certain costs could be paid out of general revenues. Some costs could be allocated among all IPA holders as a charge against all account earnings; in other cases, it may be appropriate to charge fees only to particular individuals, such as individuals making certain investment decisions.
Allocating administrative expenses to IPA participants could affect IPA accumulations. For example, one study found that 58 percent of all workers covered by Social Security in 1996 had taxable earnings of less than $20,000.(19) An annual contribution equal to two percent of compensation (as a number of proposals contemplate) would provide each of these workers with a maximum annual contribution of $400. Some have expressed concern that allocation of administrative expenses to account with relatively low balances could significantly erode any earnings.
Any IPA proposal that contemplates involvement of employers and others (e.g., financial institutions) presents the issue of whether employers or others who incur significant costs as a result of an IPA proposal are reimbursed for those costs in some way. If, for example, a financial institution is not reimbursed for its costs relating to an IPA proposal, then the financial institution will likely pass those costs through to its customers. This may include IPA account holders, if the IPA proposal permits the costs to be passed through, or other customers of the financial institution. Similarly, if the employer plan model for account administration is adopted, employers will likely pass the costs of IPA administration along to the customers of the employer, if the employer is not reimbursed for the expenses or permitted to allocate the expenses to IPA participants.
C. Administrative Issues Relating to Investments
General discussion
There are a variety of different ways in which funds in IPAs could be invested. These options generally mirror those used today under private pension plans. These options include: (1) investment by professional money managers, much like pension plan fiduciaries make investment decisions with respect to qualified pension plan investments; (2) some level of individual investment direction; and (3) statutorily mandated investments. Under (2), there are additional options. Individuals could be given a very broad choice of investments, or more limited options representing various degrees of risk and possible returns, such as those offered under the Federal Thrift Savings Plan and most private-sector section 401(k) plans. A combination of the various models could also be provided. For example, individuals could be given the opportunity to direct the investment of a portion of their IPA account balance, and the rest of the funds could be invested pursuant to investment decisions made by professional money managers. As another example, investments could be made by professional money managers, but the statute could include parameters regarding permitted investments.
The decision as to how investments will be made raises significant policy issues, which are discussed below in Part IV.B.4.
From an administrative perspective, any of the investment methods could be implemented under any of the three basic IPA models. For example, individuals could be give some investment discretion under a system of government-managed IPA accounts. Similarly, under the IRA-type model, the options available could be limited to funds meeting certain statutorily defined requirements. As a practical matter, however, if IPAs follow the individually-managed model and if investments are restricted, it is possible that some individuals will mistakenly invest IPA funds in prohibited investments.
Under any of the alternative approaches to making investments, consideration should be given as to what, if any, liability those making investment decisions have in the event improper or inappropriate decisions are made. That is, it needs to be decided whether some form of fiduciary liability should be imposed.
Participant-directed investments
If individuals are given some investment discretion, then individuals will need to be provided with informational materials regarding the various investment options. Because many individuals do not have investment expertise, educational information regarding investments may also need to be provided to help ensure that individuals make appropriate investment decisions. In some cases, the financial institution or other entity offering the investment may be relied upon to provide information regarding the investment and educational information, just as they do now with respect to IRAs and employer plan investment options. For example, employer plan money managers currently often provide seminars regarding investment strategies to plan participants. If the financial institution does not provide sufficient information, then the government or employers may need to provide additional information. The more individual investment discretion that is provided, the greater is the potential need for investment education.
If individual investment discretion is permitted, rules will also be needed regarding how often investments can be changed. A default investment may also be needed in the event that an individual does not make an investment election.
Other issues that arise if individuals are allowed to make investment decisions are how investment elections will be made and how funds will be transferred to the investments picked by the individuals. Because resolution of these issues depends in part on how IPAs are funded and how contributions are collected, these issues are discussed in below in Part III.D. (Administrative Issues Relating to Contributions).
D. Administrative Issues Relating to Contributions
In general
Any legislation creating a new system of IPAs will need to address a variety of administrative issues relating to contributions, including the following: (1) methods for collecting contributions; (2) crediting of contributions to IPAs; and (3) if participants are permitted to direct investments, transfer of funds to investment vehicles elected by participants. The need to have a contribution collection system depends in part on the method used to fund IPAs. For example, if IPAs are funded solely from budget surpluses or general revenues, then a specific collection mechanism for IPA contributions would not be necessary. Many IPA proposals, however, contemplate individual contributions. Resolution of the issues relating to contributions also depends in part on the IPA model adopted (i.e., government-held accounts, employer-sponsored plans, or individual accounts).
Government held accounts
Collection of contributions
If the government held account model is adopted, then the Federal Government would be responsible for collection of contributions, allocation of contributions to IPAs, and transfer of funds to investment managers. Under this model, a means of collecting contributions and transferring the contributions to the Federal Government would be needed. As discussed below, mechanisms exist under the present-law Federal tax system that could be used by the Federal Government to collect IPA contributions. New systems could also be developed.
One method that could be used to collect IPA contributions is the present-law payroll tax system. Under this approach, contributions would be withheld from employees and paid over by employers. Contributions for self-employed individuals would be collected in
the same manner as self-employment taxes under present law, i.e., through the estimated tax system. Utilizing the present-law payroll tax system would have the advantage that the system is already in place and is familiar to workers and employers. The ease with which the current system could be used may depend on how similar the IPA system is to the current Social Security system. For example, if IPA eligibility is significantly different from Social Security coverage, then present-law payroll systems would need to be adapted for IPA purposes. Similarly, collection of contributions using the current system would be easier if the contributions are based on a percentage of wages as defined for Social Security purposes. If there are differences between the tax bases for IPA and Social Security purposes, then employer withholding systems would be to be modified, and self-employed individuals would need to make additional calculations in computing their taxes that are not required under present law.
One possible alternative to utilizing the payroll tax system to collect IPA contributions would be to use the income tax system. Under this approach, the amount of the contributions could be considered an additional tax, subject to withholding and estimated tax rules. Additional forms and worksheets would be required to enable individuals to calculate the amount of the contribution. Compared to using the payroll tax system, this approach would place more burdens on individual workers. It could also delay the time at which contributions are collected. Another issue is that many workers who may be covered by the IPA program may not currently file income taxes. Thus, such individuals might be required to file solely because of the IPA program.
Another approach would be to utilize the income tax system, but not apply withholding and estimated tax rules. This approach would further delay the timing of contributions, and could raise significant enforcement issues.
Allocation of contributions to individual accounts
Assuming contributions are based on wages or self-employment earnings, then crediting of contributions to accounts would require accurate wage and earnings information.(20) The method used by the Federal Government under present law to credit wages and earnings for Social Security purposes could be used to credit contributions to IPAs. Under present law, employers are generally required to provide wage information (Forms W-2) to the Social Security Administration ("SSA") by the end of the February of the year following the year for which the wage information is provided. It generally takes some time before the wage information is credited to each employee's account. Crediting earnings with respect to self-employed individuals takes somewhat longer than crediting of information for employees.(21) This system could be used to determine the amount of wages and earnings, and therefore the amount of contributions, to be allocated to each individual IPA. The Federal Government could then transfer the correct amount of contributions to each IPA.(22)
Some have expressed concern that using the present-law method of crediting earnings under Social Security to allocate contributions to IPAs will mean that contributions for a year will not be allocated until well after the end of the year, with the result that investment of IPA contributions may be delayed. One way to address this concern would be to credit contributions with earnings for some period before contributions are allocated to accounts.(23) Earnings could be credited based on a statutorily prescribed rate of return, or with actual investment returns--contributions could be invested even though there has not been a reconciliation to particular accounts.
Another approach would be to require the Federal Government to credit wages to individuals more frequently than is done under present law. Such a requirement would impose additional administrative burdens on employers, the Federal Government, and individuals that would not be imposed in the absence of the IPA proposal. For example, in order to reconcile wage information more frequently than annually, employers would have to report such information more frequently to SSA, self-employed individuals would have to provide earnings information more frequently, and SSA would have to process this information more often than under present law.(24)
Transfer of contributions to investment vehicles
If individuals are permitted some investment discretion, then there will need to be a mechanism for making investment elections and for transferring funds to investment vehicles. If the Federal Government is responsible for administering investment elections, one method of making investment elections would be for individuals to file a form with their employer, who would forward the form to the government, much like wage withholding forms are completed by the worker and filed by the worker's employer. A separate system would need to be adopted for self-employed individuals. Alternatively, the individual could provide investment information as
part of the individual's tax return. A working model for such a system is the recently adopted tax refund direct deposit option. A taxpayer can direct that his or her refund be directly deposited in his or her account by providing the routing number for the financial institution and the taxpayer's account number on the tax return. In 1998 (for taxable year 1997) approximately $34 billion of refunds were directly deposited for approximately 19 million taxpayers. This number is a small fraction of workers covered by Social Security (and of individuals who would likely be covered by an IPA proposal); however, the system provides a model that could possibly be expanded.
Employer-sponsored plan model
Under the employer-sponsored plan model, employers could be required to collect contributions from employees who are covered under the IPA system and to allocate each employee's contributions to the employee's IPA. Employers that have section 401(k) plans will already have systems in place which could be used to collect and transfer IPA contributions. However, many employers, particularly smaller and medium-sized employers, do not have such plans and would need to adopt systems to remit and transfer IPA contributions. Such a proposal may also increase administrative costs for employers that already have section 401(k) plans. For example, some employees that are not covered by the employer's plan or that are not participating in the employer's plan may have IPAs. Thus, the employer may be required to administer contributions for additional employees. In addition, to the extent that the contribution base for the IPA system is different than that used under the employer's plan (e.g., the definition of compensation is different), the employer's existing systems would need to be modified.
Under the employer-sponsored plan approach, employees would make investment elections (if permitted under the proposal) through their employer. As discussed above, while employers with section 401(k) plans typically perform this function currently, requiring employers to do so as part of an IPA proposal will impose additional administrative burdens on employers. For example, employers that already have section 401(k) plans may have to adapt existing systems if the investment options available under the IPA proposal differ from those offered under the employer's plan.
Rules would be necessary to ensure that an employer (1) allocates an employee's contributions within a specified time period and (2) credits the employee's account with income for any period during which such contributions are not allocated. It may be necessary to require an employer to submit information to the Federal Government to verify that the appropriate contributions and investments have been made on behalf of employees.
Under the employer plan model, a separate system would be needed to collect, remit, and allocate contributions for self-employed individuals.
Individual accounts
Under an individual account system, either individuals could be required to make contributions to an individual account or the Federal Government could collect contributions (such as through the present-law payroll tax system) and remit such contributions to a financial institution designated by the individual or established by the Federal Government.
If individuals are required to make the contributions directly, then reporting requirements would be needed to guarantee that contributions are made in the correct amount and on a timely basis. Rules enforcing the contribution requirements might also need to be developed.
If the Federal Government collects the contributions and remits them to a financial institution, rules would be necessary to ensure that the financial institution (1) allocates contributions to an individual's account within a specified period of time and (2) credits the account with earnings for any period during which such contributions are not allocated. It may be necessary to require the financial institution to submit information to the Federal Government to verify that the appropriate contributions have been made on behalf of such individuals.
1. Access to funds prior to retirement
General discussion
Precluding access to funds in IPAs is necessary to ensure that the accounts are not eroded through use of the funds for nonretirement purposes. Prohibitions on early access to funds will also be of importance if the private accounts are coordinated with Social Security, e.g., if some or all of the account balance reduces the amount otherwise payable under Social Security. Without restrictions on preretirement withdrawals, individuals would simply withdraw funds before retirement in order to minimize the reduction of Social Security benefits.(25)
As a practical matter, it may be difficult to restrict access to private accounts. Pressures under present law have resulted in numerous exceptions to the 10-percent early withdrawal tax for IRA and, in some cases, qualified plan distributions. For example, the 10-percent early withdrawal tax does not apply to IRA withdrawals for education, medical, and first-time homebuyer expenses. In addition, many employer-sponsored retirement plans permit individuals to borrow from their retirement accounts.(26)
The ability to maintain withdrawal restrictions may depend in part on how individuals view the private accounts. If they are viewed as part of Social Security or as a pension benefit, then they may be more willing to not have access to funds prior to retirement, as that is consistent with the way in which Social Security works today (as well as private defined benefit pension plans). On the other hand, if individuals view private accounts more as personal savings, or as supplements to other retirement income, they may be more opposed to restrictions on preretirement access to funds.
To the extent that preretirement access is prohibited, this prohibition should extend to loans based on the account balance as well as outright distributions. While theoretically an individual will repay the loan, a loan program may simply result in reduction of retirement benefits if the loan is not repaid.
Access to funds for disability
A separate issue is the extent to which IPA balances will be paid prior to retirement on account of a participant's disability. If either the IPA account balance or an annuity based on such balance can be paid on account of disability, then special rules will be necessary.
These rules must define what constitutes a disability for which payments are permitted and specify the mechanism by which the IPA administrator verifies that (1) there is a valid disability and (2) such disability continues for the period during which payments are made.
Issues associated with particular types of accounts
Government held accounts.--If private accounts are held and administered by the Federal Government, withdrawal restrictions and disability provisions will be relatively easy to enforce, as the funds simply will not be made available until the individual is entitled to a distribution.
Employer-sponsored plans.--Withdrawal restrictions could be enforced under an employer plan approach just as they are under present law with respect to certain types of qualified plans.
If withdrawals are allowed in the case of disability, then additional rules may be necessary. If there is a certification required before disability benefits are paid, it may be necessary to have the IPA participant provide adequate verification to the Federal Government, which would then direct the employer to commence disability payments. Alternatively, the participant could be required to provide adequate verification of disability to the employer administering the plan and the employer could be required to submit such verification to the Federal Government.
Issues may arise with respect to the treatment of funds once an employee has terminated employment with the employer. Under present law, employers often do not wish to maintain accounts for individuals who are no longer connected to the employer. Maintaining such accounts can create administrative difficulties for the employer, for example, the employer may have difficulty locating the former employee in order to send required notices or even to make benefit payments. Thus, if the employer plan model is followed, it may be desirable to consider allowing the employer to transfer the funds elsewhere (e.g., to another employer plan, to a private account, or to a government held account) once an employee has separated from service.
Individual accounts.--Financial institutions are generally required to make funds available to depositors, so that some changes to the rules governing such institutions may be needed to prevent early access to funds held in individual accounts with private institutions.
Tax penalties can be imposed to make it unattractive to individuals to access the funds before retirement, similar to the present-law 10-percent early withdrawal tax applicable to IRAs and tax-qualified retirement plans. However, a much higher penalty tax than 10-percent would likely be necessary to prove a true disincentive to withdraw funds early, particularly given any subsequent interaction with Social Security benefits.
Administration of payments on account of participant disability will be much more difficult in the case of individual accounts. A mechanism will be required to ensure that the disability is verified. This could be accomplished by requiring the participant to submit appropriate documentation to the Federal Government, which would then direct the financial institution to make payments to the participant or to purchase a disability annuity.
2. Portability of account balances
General discussion
Under present law, Social Security benefits are portable-benefits and contributions are not dependent on working for a particular employer-and each worker has a single "account" within Social Security to which earnings and quarters of coverage are credited. Employer-sponsored retirement plans also offer some measure of portability-nonannuity distributions can generally be rolled over tax free to another employer retirement plan (if the plan accepts such rollovers) or to an IRA. Providing portability of new IPAs would enable individuals to maintain a single account with all their IPA accumulations. Maintaining a single account will generally minimize administrative issues for individuals. In addition, maintaining a single account for each individual will make coordination with Social Security easier. If an individual has more than one account, then all account balances will have to be combined in order to properly coordinate with Social Security benefits. This could create difficulties if individuals have several accounts (particularly if the individual did not maintain adequate records regarding his or her accounts).
Issues associated with particular types of accounts
Government held accounts.-If private accounts are administered by the Federal Government, then each worker will have a single IPA to which contributions are made (and earnings credited) regardless of the particular employer for whom the individual works.
Employer-sponsored plans.-Under the employer plan model, individuals could have more than one IPA if the individual works for more than one employer. Portability could be achieved by providing that accounts held by one employer are transferred directly to another IPA account held by the individual or the Federal Government upon separation from service with the employer. Employers will likely prefer that such transfers occur; under the current employer-plan system, employers can encounter difficulties keeping track of accounts for individuals who have no current connection with the employer. Among the problems that employers can encounter is that the former employee does not inform the employer of address changes.
Individual accounts.-If IPAs follow the IRA model, then an individual's account would not be dependent upon the employer. However, if individuals are to have only one IPA account, then changes in the law may need to be made so that an individual cannot set up more than one IPA. Even if individuals are by law precluded from maintaining more than one IPA, there may be instances in which individuals inadvertently set up more than one account. Rules would be needed to address such situations.
3. Form of distributions
General discussion
One issue that will need to be addressed under any private account system is what distribution forms are required to or may be made available. If the private accounts are to operate in a manner similar to Social Security, then an annuity would need to be made available. This would require the purchase of an annuity contact with the account funds. An annuity may be a valuable form of benefit, because it ensures a stream of payments throughout an individual's life time. Payments over the life expectancy of the individual may approximate an annuity; however, in some cases the individual will outlive his or her life expectancy. It may also be easier to coordinate private account benefits with Social Security if the same form of benefit payment is available.
Whether optional forms of benefit may be offered will also need to be addressed under any private account system. Some optional forms may not be consistent with goals of providing retirement income security. For example, if payments can be made in a lump sum, there may be more of a risk that individuals will not have sufficient retirement income throughout his or her retirement. Permitting individuals to choose among various different types of distribution options may create administrative difficulties. Some limits on the choices available as well as the ability to change the form of distribution once distributions have begun may be helpful to reduce administrative burdens.
See, also, the issues relating to spousal and survivor benefits in Part III. F., below, for a discussion of issues (including spousal consent to benefit payment) relating to spousal rights.
Issues associated with particular types of accounts
Government held accounts.-Under a system that utilizes government accounts, distributions options can be easily limited. If individuals are permitted to choose among more than one distribution option, then mechanisms for communicating the choices to individuals, and for individuals to make elections, will need to be created.
Employer-sponsored plans.--Forms of distribution could be limited under the employer-sponsored plan approach by permitting only certain forms of benefits to be made available. Under present law, many plans provide optional forms of benefit, with some restrictions as to the options available and the ability to change between options.
Individual accounts.-The same issues described above with respect to timing of distributions if distribution options are to be limited. Thus, either the laws relating to banks and other institutions that currently hold IRA assets will need to be changed, or a tax penalty may need to be imposed to enforce any restrictions on the form of distributions.
If forms of distribution are not to be restricted, then the administrative difficulties arising with respect to electing and changing distribution forms will not be as great under an individual account approach; the individual can simply take withdrawals from the account as needed.
4. Coordination with Social Security
It is anticipated that IPA balances may, in some way, be coordinated with Social Security. Such coordination could take a variety of forms. For example, IPA funds could reduce Social Security benefits on a dollar for dollar basis. Alternatively, some portion of IPA funds could offset Social Security benefits, and some portion of IPA funds could be retained by the individual. Coordination of IPA balances with Social Security raises a number of issues. Specific issues will depend on the precise coordination mechanism used; however, some general issues are discussed below.
Vesting
One issue raised by coordination with Social Security is the extent to which individuals have a vested right to their account balances. Under present law relating to qualified retirement plans, an individual is considered to be vested in retirement benefits if they have a nonforfeitable right to receive the benefits either currently or at some point in the future. Under employer-sponsored retirement plans, if an individual is vested in his or her benefits, then the individual has a right to receive the entire account balance. If the individual dies before receiving his or her entire interest in the plan, then the remaining interest is paid to the individual's beneficiary. If the individual uses the account balance to purchase an annuity, then any death benefit payable depends on the terms of the annuity purchased by the individual.
If some portion of IPA balances are used to pay benefits that would otherwise be payable under Social Security, then the individual may be said to have a vested right only to the extent that the IPA balance is not used to pay Social Security benefits. That is, the amount used to pay Social Security is in essence "forfeited." If instead of reducing IPA balances, Social Security benefits are reduced by some portion of the IPA balance, then the individual could be said to have a vested right to his or her IPA balance. However, the economic effect on the individual would be the same-in either case the IPA balance has been used as a method of prefunding Social Security benefits. The economic effects of coordinating IPAs with Social Security is discussed in detail in section Part IV. B.3., below.
Benefit guarantee
Social Security currently provides a guaranteed benefit. Policy makers will have to decide whether some minimum level of benefit will be guaranteed, or whether Social Security benefits will be based solely on IPA balances. If there is no benefit guarantee, then the individual will bear the risk of loss or poor investment returns on IPA balances. If there is a guaranteed minimum benefit (e.g., the present-law level of Social Security benefits), then the individual bears the risk of invest loss or poor returns with respect to the extent of potential benefits in excess of the minimum benefit. While providing a guarantee may help ensure adequate retirement income security, it may also affect investment choices.
In addition to investment risks, IPA balances could be reduced to the extent there is fraud or other types of mismanagement. For example, in some cases employers may not forward contributions required to be allocated to an individual's account. In addition, funds could be embezzled or stolen from investment funds. Such issues would need to be addressed, whether through some Federal guarantee or private insurance against theft.
Administrative issues associated with Social Security coordination
Regardless of the particular way in which IPAs are coordinated with Social Security, calculations will be need to be performed in order to determine the proper amount of the offset. The calculations could be performed by a government agency, individuals, or financial institutions holding IPAs. In general, there is likely to be more consistency in making any calculations if they are performed by a single source. If IPAs are held by private financial institutions, then such institutions may need to report IPA account balances and activity to the Federal Government to help ensure that any offset with Social Security is correctly calculated. Consideration will need to be given as to whether annuitization of the IPA balance is necessary to properly coordinate with Social Security.
The time at which any offset is made will also be an issue. It may be easier to fix the account balance at a specified date, e.g., when retirement distributions begin, in order to minimize the number of calculations that need to be made. The account balance will change over time as distributions are made; additional investment earnings and losses may be credited to the account, and additional contributions may be made if the individual is still working. However, using a specified date could change individuals' investment decisions. For example, if additions to the IPA balance after retirement do not reduce Social Security (i.e., the individual retains any additions to the IPA after reaching retirement age), then the individual may make more conservative investment decisions after reaching retirement age than before, because the individual will directly receive the benefit of any investment gains.(27)
5. Administrative issues with respect to taxation of distributions(28)
In general, the administrative issues that arise with respect to taxation of distributions are similar regardless of the kind of account established. Because the individual has the burden of properly computing and reporting taxable income, it is likely that the individual will bear the administrative burdens associated with any system of IPA taxation. While record keeping and reporting requirements can be imposed on institutions that maintain the IPA to assist individuals in computing the amount of taxable income due to IPA withdrawals, in general, the more complicated the tax rules associated with IPAs, the greater the burden will be on individuals.
The fewest administrative issues arise if distributions from private accounts are either (1) fully includible in income, or (2) fully excludable from income. If distributions from the accounts are taxable, then information reporting regarding distributions, as is currently done with respect to IRAs and employer-sponsored plans, may be desirable. If distributions are taxable (in whole or in part) then whether to adopt a withholding system should be considered. Under present law, there is optional withholding with respect to IRAs and employer-sponsored retirement plans.
Additional administrative issues arise if the account consists in part of amounts that will be taxable upon distribution and in part of amounts that will not be taxable upon distribution. For example, if the accounts were taxed like present-law nondeductible IRAs, then the amount representing after-tax contributions would not be taxed upon distribution, but earnings on contributions would be. The difficulty that arises under such an approach stems from the need to keep track of contributions. The present-law analogies (i.e., nondeductible IRAs and after-tax contributions to employer plans) may not provide a very good guide, as it is generally acknowledged that record keeping regarding contributions can be difficult, and is generally the responsibility of the individual. In addition, ordering rules would need to be developed to determine what portion of a distribution, if any, was taxable. Similar rules under present law can be difficult to apply.
Another method of taxing distributions would be to follow the present-law Social Security system, under which the amount includible in income is based upon the individual's modified adjusted gross income. If such an approach were adopted with respect to the accounts, then the burden of determining the taxable amount would fall on the individual, as under present law. The difficulty of determining the taxable amount would depend on the particular rule adopted.
Other issues may arise due to the coordination of IPAs with Social Security. For example, some proposals have suggested that the amount of the IPA that reduces Social Security benefits should receive different tax treatment than the amount of the IPA balance that is not integrated with Social Security. For example, suppose an individual has an IPA balance of $100, and that under the proposal one-half of IPA balances reduce Social Security benefits. If the individual withdraws the $100, then his Social Security benefits are reduced by $50. One possible approach would be to tax the $50 that reduces Social Security benefits in the same manner that Social Security benefits are taxed and to apply a different rule to the remaining $50. Any rule that provides different tax treatment for different portions of the account would raise additional administrative issues.
If IPA balances are fully or partially taxable, then consideration should also be given as to whether withholding is required or permitted (e.g., IRA distributions are subject to voluntary withholding under present law).
6. Miscellaneous distribution issues
A variety of other distribution issues would need to be addressed under any proposal to create private accounts, including whether the accounts are protected from the individual's creditors; whether, if funds are not held by the government, accounts can be transferred from employer to employer or to some to other type of arrangement; and whether an individual can change financial institutions or investment managers without receiving a distribution.
F. Survivor and Spousal Rights
In general
Any individual private account proposal should specify whether the account of a worker is subject to State community property laws or is otherwise subject to assignment or alienation. A decision could be made to let State laws control or, alternatively, a separate Federal system could be established to override the applicability of State law to the balances in the individual private account. A system similar to the rules applicable to qualified retirement plans could be adopted in which the amounts in an individual private account generally are not subject to assignment or alienation, but specified rights are provided for current and former spouses of plan participants.
The present-law social security system and the present-law qualified retirement plan system recognize the rights of certain survivors of a deceased worker and certain divorced spouses. A variety of issues relating to survivor and spousal rights are raised by the creation of private accounts. The work and earnings characteristics of women relative to men may affect the relative changes in benefits if a private account proposal is enacted. Thus, in designing a private account proposal, careful consideration will be required of the extent to which an individual other than a worker has a right to the assets accumulated in the worker's account.
The first issue that must be addressed is whether a spouse of a worker acquires rights to the amounts accumulated in the worker's account.(29) Some private account proposals do not acknowledge the rights of former and surviving spouses to the amounts accumulated in a worker's account. Some people will argue that it is necessary to recognize the rights of a spouse of a worker so that spouses who elect to work inside the home will not be at a disadvantage relative to other spouses who work outside the home. Such individuals will also cite the fact that women, on average, have lower income during retirement than men as further support for the need to provide former and surviving spouses with a right to assets in a worker's private account.
If it is determined that a former or surviving spouse will be given rights to the worker's account, then the nature of the rights of such spouses must be defined. Some of the possible options are the following:
Under any of the options described above, it would be necessary to specify when the rights of the nonworker spouse become nonforfeitable (e.g., upon death of the working spouse, upon the working spouse attaining a specified age, etc.). In addition, if it is assumed that a spouse acquires certain rights relating to a worker's account, but does not have the right to the creation of a separate account for such spouse, then the issues described below must be addressed.
Spousal and survivor rights upon death before retirement
The initial decision that must be made is whether a worker has a vested right to benefits accumulated in his or her account prior to attaining retirement age. If the amounts accumulated in a worker's account are fully nonforfeitable (i.e., if either the worker or the worker's beneficiaries are entitled to receive them even if the worker dies prior to retirement age), then it is necessary to determine whether a surviving spouse of a worker is entitled to the amounts accumulated in the worker's account at death prior to retirement age or whether the distribution of amounts accumulated in the account is governed by the worker's beneficiary designation. In addition, it will be necessary to determine whether the worker's spouse is given a priority right to the amounts accumulated in the account such that the spouse is required to consent to any beneficiary designation that is not such spouse.
It may be possible to design a system that is similar to the present-law social security system in which the rights of survivors are determined by reference to the worker's account balance and the characteristics of the survivors. Under such a system, the amount paid to the survivors may be limited to a portion of the worker's account balance and only for a limited period of time (e.g., until a minor child attains age 16). Under this type of system, the amounts accumulated in the worker's account are only nonforfeitable to the extent the worker has survivors who meet certain criteria and, therefore, would be entitled to receive a portion of the worker's account balance. The portion of the worker's account that is not paid to such survivors would then be forfeited.
Spousal rights upon retirement age
When a worker attains retirement age, it is necessary to specify whether the worker's spouse has the right to consent to any optional form of benefit payment that does not provide a joint and survivor annuity for the worker and spouse.
Spousal rights upon divorce
A separate issue that must be addressed is whether a nonworker spouse acquires or retains rights to the amounts accumulated in a worker's account upon divorce of the couple. If the nonworker spouse either has a stated legal right (e.g., under State community property laws) to all or a portion of the worker's account or is able to negotiate a right to such account in the course of divorce proceedings, it will be necessary to develop rules and procedures for satisfying the divorced spouse's rights. For example, if a former spouse has the right to a portion of the worker spouse's account balance, it would be necessary to determine whether such former spouse is (1) entitled to the payment of such amounts when either the former spouse or the worker spouse attained retirement age, (2) permitted to withdraw the amounts immediately from the worker's account, or (3) permitted to roll the amounts in the worker's account either into the former spouse's own account or into some other retirement vehicle, such as an IRA.
Issues associated with particular types of accounts
Government held accounts.-In the case of a government held account, the administration of spousal and survivor rights could be administered in much the same manner as such rights are administered under the present-law FERS program. Participants could be required to get written spousal consent to distributions (and to the form of distributions and the designation of beneficiaries) and survivors could submit claims for benefits to the governmental body administering the plan.
Employer-sponsored plans.-In the case of an employer-sponsored plan, rules could be developed to address the rights of current and former spouses and surviving spouses that are similar to the rules applicable under present law to qualified retirement plans. Employers could be required to secure written consent from a participant's spouse prior to making distributions under the plan. Similarly, the employer could require written consent to the form of distributions and the designation of beneficiaries under the plan. An issue that arises is whether the Federal Government would require copies of such consents in order to verify that an employer is administering the plan in accordance with the applicable law.
If employers are required to administer the rules relating to spousal and survivor benefits, the employers will want (1) rules that are clear and easy to administer and unlikely to result in disputes, (2) the Federal Government to make determinations with respect to any dispute that does arise, and (3) to be protected from any liability to participants or their current or former spouses or other beneficiaries if they follow the applicable rules.
Individual accounts.-Under an individual account system, it will be necessary to develop procedures for handling any rules relating to spousal and survivor benefits. In general, financial institutions will not be accustomed to dealing with such matters as spousal consent and will prefer rules that are clear and easy to administer. Many of the issues are similar to those for employer-sponsored plans, although financial institutions are likely to be less willing to administer the types of written consents that could be required.
Social Security, individual savings, and employer pensions are commonly referred to as parts of a "three-legged stool" providing retirement income security. If any significant changes are made to one of these elements, those changes could impact the other "legs" of the "stool." In particular, creation of a new system of private accounts that are integrated with Social Security could affect the operation of employer-sponsored retirement plans. It is difficult to examine the possible effects on employer plans in the absence of a specific IPA proposal. However, some general observations may be made.
As discussed in Part IV.B.2. below, one possible response of individuals to a new system of IPAs could be to reduce other saving. One way in which this might occur would be to reduce savings through employer-sponsored retirement plans. For example, some individuals may reduce their elective contributions to a section 401(k) plan. Alternatively, employees could seek reductions in employer contributions to retirement plans and an increase in cash wages or other benefits. Employers may be concerned about reductions in employer sponsored retirement plan benefits for a variety of reasons. Some employers use retirement plan benefits as a means of encouraging continued employment and rewarding long service (or, in other cases, in encouraging early retirement as part of downsizing). Some employers may also be concerned that their plan would have difficulty meeting applicable nondiscrimination rules. For example, if nonhighly compensated employee reduce their elective deferrals under a section 401(k) plan in response to an IPA proposal, then the plan might not satisfy the nondiscrimination test applicable to section 401(k) plans.
Present law contains rules that permit qualified plans to be formally integrated with Social Security benefits. These rules are based on the premise that employers are contributing to Social Security and should in essence receive credit for such contributions in designing qualified plans. In general, the integration rules provide that a qualified plan is not considered to discriminate in favor of highly compensated employees merely because the contributions and benefits under the plan favor highly compensated employees by more than the "permitted disparity." In the case of a defined contribution plan, the integration (or permitted disparity) rules permit a greater level of contribution for compensation in excess of the integration level than for compensation below the integration level. In the case of a defined benefit plan, the permitted disparity rules allow benefits provided in excess of the integration level to exceed benefits provided below the integration level. Defined benefit plans may also offset plan benefits by an "offset allowance." The permitted disparity rules will need to be examined if any significant changes are made to Social Security benefits and contributions. Additional issues will arise if an IPA proposal is adopted. One issue that may arise is the extent to which the permitted disparity rules would need to be revised to take into account the fact that a portion of Social Security benefits is funded with an IPA.
H. Other Administrative Issues
Enforcement and claims procedures
No matter what system of individual accounts is adopted, a variety of types of errors and omissions could occur. For example, contributions may not be allocated properly to individual accounts, errors may be made in implementing participant investment decisions (if allowed under the proposal), employers may not file required information returns, and employers may not deposit contributions as required. Wilful violations of the law may also occur, for example, funds may be stolen or impermissible fees may be charged. Rules will be needed to deal with detection and correction of mistakes and errors, and penalties will be needed for wilful disregard of the law. Procedures will also be needed to allow individuals to file claims if they believe an error has occurred.
Any enforcement system will need to be tailored to the specific proposal, as well as the specific violation. For example, if the current payroll tax system is used to collect contributions, then the present-law enforcement rules under the payroll tax system may be used to enforce IPA obligations. Decisions will need to be made as to what remedies are appropriate for particular mistakes or violations. For example, if an error regarding investments has resulted in a loss to some plan participants, equity may require that they be made whole. It also will need to be decided how errors in an individual's favor will be corrected.
Effective date
Any new IPA system will require some lead time to implement. For example, necessary record keeping and other systems will need to be in place. Implementation of the Federal Thrift Savings Plan took approximately three years from enactment. Analysis of this implementation process may provide a guide as to what kind of start-up issues may arise under a new IPA proposal. However, additional issues may arise under an IPA proposal that applies to all workers, if for no other reason than many more individuals and accounts would be involved. The necessary lead time will depend on the particular proposal adopted and the extent of changes to existing systems required.
IV. ECONOMIC ISSUES RELATING TO PRIVATE ACCOUNTS
A. Private Account Accumulations and Annuity Values
The amounts that accumulate in IPAs would depend on the annual contribution levels, the rate of return on the contributions net of all expenses, and the length of time over which contributions are made. Table 1 shows the accumulations that would result under a proposal to contribute two percent of payroll over a 35 year time period for varying wage levels and rates of return. The 5.5 percent real rate of return that is used for one of the examples is the one Professor Martin Feldstein of Harvard University cites as being the average annual return over the past 50 years for a portfolio that is weighted 60 percent in stocks and 40 percent in bonds.(30) However, it is important to recognize that if any IPA proposal does result in an increase in national saving it is also likely to have an impact on future rates of return. For an economy to absorb a large increase in saving, which many proponents claim would result from IPAs, it would generally be expected that average rates of return would fall to absorb the new saving. The reason for this is assets are first invested in better investment opportunities and incremental savings are invested in more marginal investment projects, which can be expected on average to produce a lower rate of return. In addition, it is important to recognize that rates of return for individuals will vary based upon the investment decisions made by each individual. Many individuals will be conservative with their investments and avoid stocks, and thus their rates of return may be lower than the average for those that invest in stocks.(31) However, investing in stocks is not a guarantee of a high rate of return, and low or negative rates of return will certainly result for some individuals.
Table 1.--IPA Accumulations Per Couple
at Age 65, Year 2033
| Real Rate
of Return |
Real Annual Wage Levels (and Annual Contributions) per Couple | |||||
| $20,000
($400) |
$40,000
($800) |
$60,000
($1,200) |
$80,000
($1,600) |
$100,000
($2,000) |
$120,000
($2,400) | |
| 3% | $24,910 | $49,821 | $74,731 | $99,642 | $124,552 | $149,462 |
| 5.5 % | $42,306 | $84,612 | $126,918 | $169,224 | $211,530 | $253,836 |
| 8% | $74,441 | $148,882 | $223,323 | $297,763 | $372,204 | $446,645 |
Note: Assumes annual contributions beginning in 1999 for 30 year old taxpayers. Contributions are at a two percent contribution rate, and wages are assumed split evenly between the spouses. Additionally, the accumulations shown assume no account expenses or taxes during the period of accumulation.
The accumulations listed in Table 1 assume 35 years of contributions. Thus, these balances are for year 2033, assuming IPA contributions began in 1999. For the current baby- boom generation, accumulations by age 65 would be much smaller than are shown in Table 1, as such individuals are much nearer to retirement. Hence, any IPA proposal would have less of an effect on current baby boomers. For example, a couple that is currently 15 years from retirement and has combined wages of $60,000 would have accumulated only $28,369 by retirement at the 5.5 percent rate of return as compared to the $126,918 that a younger couple would accumulate over a 35 year period. Table 2 shows accumulations for taxpayers retiring at various years in the future, and at various income levels.
Table 2.--IPA Accumulations Per Couple at Retirement
|
Real
Annual
Wage
Level |
Real Annual Contribution |
Retirement Year | ||||||
| 2005 | 2010 | 2015 | 2020 | 2025 | 2030 | 2035 | ||
| $20,000 | $400 | $2,907 | $6,154 | $10,399 | $15,946 | $23,196 | $32,671 | $45,055 |
| $40,000 | $800 | $5,814 | $12,308 | $20,797 | $31,891 | $46,391 | $65,342 | $90,110 |
| $60,000 | $1,200 | $8,720 | $18,463 | $31,196 | $47,837 | $69,587 | $98,013 | $135,165 |
| $80,000 | $1,600 | $11,627 | $24,617 | $41,594 | $63,783 | $92,783 | $130,684 | $180,220 |
| $100,000 | $2,000 | $14,534 | $30,771 | $51,993 | $79,729 | $115,978 | $163,355 | $225,275 |
| $120,000 | $2,400 | $17,441 | $36,925 | $62,391 | $95,674 | $139,174 | $196,026 | $270,329 |
Note: Assumes annual contributions beginning in 1999 and ending at retirement for the year shown. Contributions are at a two percent contribution rate, a 5.5 percent real return is assumed, and wages are assumed split evenly between the spouses. Additionally, the accumulations shown assume no account expenses or taxes during the period of accumulation.
The IPA accumulations could be converted to a life annuity (e.g., through the purchase of a commercial annuity contract) at retirement to guarantee a steady income stream over the life of the retiree or over the lives of the retiree and his or her spouse. If annuitized, these accumulations would provide insurance against living longer than average and having one's retirement resources run out prior to death, in much the same way that Social Security does.
Of course, if the individuals covered by the annuity contract live a shorter period than the average life expectancy, the purchasers would have been better off in retrospect had they not purchased the annuity. Table 3 below shows the annual annuity value, per couple, of the IPA accumulations shown in Table 1. Amounts not yet paid to the annuitant are assumed to earn the real rate of return stated in the table, and no administrative expenses or other costs are assumed.(32) For the purposes of the annuity calculation it is assumed that a level amount would be funded until the last of the spouses dies, and that on average that would occur after 25 years for a couple both aged 65 at retirement.(33) Table 4 shows similar annuity values for the IPA accumulations shown in Table 2 for persons retiring in the near future, who would have smaller accumulations in their IPAs.
Table 3.--IPA Annual Real Annuity Value Per Couple
at Age 65, Year 2033
| Real Rate
of Return |
Real Annual Wage Levels (and Annual Contributions) per Couple | |||||
| $20,000
($400) |
$40,000
($800) |
$60,000
($1,200) |
$80,000
($1,600) |
$100,000
($2,000) |
$120,000
($2,400) | |
| 3% | $1,418 | $2,835 | $4,253 | $5,670 | $7,088 | $8,505 |
| 5.5 % | $3,118 | $6,235 | $9,353 | $12,470 | $15,588 | $18,705 |
| 8% | $6,892 | $13,789 | $20,684 | $27,578 | $34,473 | $41,367 |
Note: Assumes annual contributions beginning in 1999 for 30 year old taxpayers. Contributions are at a two percent contribution rate, and wages are assumed split evenly between the spouses. Additionally, the accumulations shown assume no account expenses or taxes during the period of accumulation. At retirement, a joint/survivor annuity paying level benefits is purchased, with the survivor expected to live 25 years from age 65 according to Internal Revenue Service life expectancy tables of Publication 590. Unpaid annuity amounts are assumed to earn the same stated real return as during the accumulation phase of the IPA balance that purchased the annuity. No costs of selling or annuity administration are assumed.
Table 4.--IPA Annual Real Annuity Value Per Couple
at Retirement
|
Real
Annual
Wage
Level |
Real Annual Contribution |
Retirement Year | ||||||
| 2005 | 2010 | 2015 | 2020 | 2025 | 2030 | 2035 | ||
| $20,000 | $400 | $214 | $453 | $766 | $1,175 | $1,709 | $2,408 | $3,320 |
| $40,000 | $800 | $428 | $907 | $1,533 | $2,350 | $3,419 | $4,815 | $6,640 |
| $60,000 | $1,200 | $643 | $1,361 | $2,299 | $3,525 | $5,128 | $7,223 | $9,960 |
| $80,000 | $1,600 | $857 | $1,814 | $3,065 | $4,700 | $6,837 | $9,630 | $13,281 |
| $100,000 | $2,000 | $1,071 | $2,268 | $3,831 | $5,875 | $8,546 | $12,038 | $16,601 |
| $120,000 | $2,400 | $1,285 | $2,721 | $4,598 | $7,050 | $10,256 | $14,445 | $19,921 |
Note: Assumes annual contributions beginning in 1999 and ending at retirement for the year shown. Contributions are at a two percent contribution rate, a 5.5 percent real return is assumed, and wages are assumed split evenly between the spouses. Additionally, the accumulations shown assume no account expenses or taxes during the period of accumulation. At retirement, a joint/survivor annuity paying level benefits is purchased, with the survivor expected to live 25 years from age 65 according to Internal Revenue Service life expectancy tables of Publication 590. Unpaid annuity amounts are assumed to earn the same stated real return as during the accumulation phase of the IPA balance that purchased the annuity. No costs of selling or annuity administration are assumed.
B. General Economic Issues
1. Overview
A number of important economic issues arise with respect to the possible establishment, funding, and administration of a system of IPAs. At the individual level, the key questions concern how such accounts would be funded, how they would be taxed, what level of accumulations could be expected in the accounts at retirement, and what interactions, if any, the accounts would have with the current Social Security system. At the national level, the key questions are whether such accounts can be expected to increase national saving, and whether they can be expected to provide adequate retirement income in conjunction with the Social Security system. The combination of decisions with respect to funding, taxation, and interaction with Social Security would determine the net effect of any IPA proposal on the overall progressivity of the tax and benefit system as well as on the intergenerational distribution of tax burdens.
Though the current interest in individual accounts owes its origin, in part, to the long-term funding problem of the current Social Security system, a system of individual accounts could be established that has no connection to the current Social Security system. Indeed, such accounts already exist in many forms today, including IRAs and section 401(k) plans. Such accounts are privately managed and receive favorable tax treatment and thus provide a model for many individual account plans currently under discussion.(34) To the extent that an individual account plan is effectively an expansion of IRAs or section 401(k) plans, the economic issues involved mirror those for the establishment of IRAs, and include such issues as the distribution of the tax benefits and whether such plans stimulate saving.
For the purposes of most of the economic analysis to follow, it is assumed that the IPA accounts would be integrated with Social Security in some way to cause a reduction in present-law Social Security benefits that is proportional to one's IPA accumulations. Without such an interaction, the IPAs would not be an instrument for addressing the long-term projected Social Security funding shortfall. A system of IPA accounts that is linked to Social Security would continue to raise the same economic issues that attend other saving vehicles, and would include such issues as the impact such accounts would have on national saving. The link to Social Security benefits also raises additional economic issues. Reducing Social Security benefits by IPA balances is implicitly a tax on such benefits (or the IPA balances). Issues associated with the interaction with Social Security include how the implicit tax would be imposed, how the burden of the tax would be borne both within and across generations, and how investment restrictions imposed to limit the risk of accounts could distort capital markets. These and other issues are discussed below.
2. Impact on national saving
Economists generally concur that increased national saving would be in the interest of the long-run economic health of the U.S. economy. Without adequate national saving, a nation may be constrained in its ability to undertake investments that are necessary to maintain and improve the capital stock.(35) A larger capital stock would mean more productive workers and higher future living standards.
The impact of any IPA proposal on national saving would depend on how the IPAs are financed. If new tax revenues are raised to fund the accounts, national saving would increase unless taxpayers reduced their other savings by the full amount of the tax increase necessary to fund the IPA. If taxpayers reduced their current consumption to fund at least a portion of the tax increase that funded the IPAs, national saving would rise.
Some proposals would use the projected Federal budget surpluses to fund IPAs. Because national saving is equal to the sum of private saving (which includes personal saving and business saving) and government saving, a government surplus (i.e., government saving) means that the government is contributing to national saving (a government deficit would mean that the government is borrowing and reducing national saving). Because the Federal Government is projected to run growing surpluses, national saving would increase if the surpluses actually occur and are not offset by decreases in private saving. Again, because national saving is equal to the sum of private saving and government saving (i.e., surpluses), trading a dollar of this projected government saving for a dollar of private saving would leave national saving unchanged. Reducing this projected government saving without increasing private saving would cause national saving to fall from the levels it otherwise would have attained. If, for example, the projected surpluses are used to finance tax cuts or spending increases, government saving would be reduced. Depending on the policies financed through the tax cuts or spending increases, private saving may or may not increase by the amount by which government saving falls.
The impact on national saving of using surplus revenues to fund IPAs would depend on what one assumes would be the level of national saving in the absence of such use of the surpluses, which in turn depends on the alternative uses of the projected surpluses. The alternative uses of the projected budget surpluses would include (1) using the surpluses to buy down the national debt, (2) using the surpluses to finance tax cuts, or (3) using the surpluses to increase government spending.
Compared to the option of using the surpluses to buy down the national debt, IPA proposals would likely have an indeterminate effect on national saving, even though they are likely to boost personal saving. National saving would be unchanged if, instead of using the surpluses to buy down the national debt, it is effectively used to increase personal saving dollar for dollar (such as, perhaps, in an IPA). That is, a dollar of government saving (buying down the debt) would be traded for a dollar of personal saving (the IPA), leaving national saving unchanged. National saving would fall, relative to the level it otherwise would have been under the assumption that the government runs a surplus, if the system of IPAs were established and individuals made any reductions in other personal savings as a result. This could occur if some individuals choose to reduce other savings in response to the establishment of an IPA on their behalf because they feel that their current savings and saving rate are sufficient to meet their retirement and other saving needs. To the extent that any individuals do reduce other savings in response to an IPA contribution, then the full dollar IPA contribution would not represent a full dollar increase in personal saving.(36) And because each dollar of financing for the IPA represents a dollar that could have been used to increase national saving by buying down the debt, the net effect of this and the reduction in other personal saving implies that national saving would be less than it otherwise would have been. Finally, national saving would rise, relative to the level it otherwise would have been under the assumption that the government runs a surplus, if the system of IPAs were established and individuals increased other personal savings as a result. This could occur if, in response to the establishment of the IPA, some individuals were made more aware of the benefits of saving and chose to increase their other personal saving as a result. The magnitude of this response by some individuals would, however, have to exceed any reduction in other savings from other individuals.
Compared to the option of using the surplus either to finance general tax cuts or to increase spending on government programs, the establishment of IPAs would almost certainly increase national saving. While some portion of a tax cut would be saved and any increased government spending would free up other resources a portion of which could be saved, neither of these responses is likely to have the same effect on national saving as would a system of mandatory personal IPA saving. Although some individuals might decrease other forms of saving as a result of the forced personal IPA saving, many individuals would not have sufficient savings to do so even if they desired, and for these individuals personal savings would increase. So long as the individuals who decreased their non-IPA personal savings did not do so by more than a dollar for each dollar of IPA contributions, national savings would rise.(37)
The above discussion has assumed that individuals would have no access to IPA funds until retirement. If penalty-free access to the IPA funds were allowed for specified purposes, such as is allowed under present law from IRAs and employer-sponsored retirement plans, the potentially positive impact on national saving would be diminished. If access to the IPA funds were allowed for any purpose upon payment of a penalty, such as is allowed under present law from IRAs, any increment to national saving would be diminished. The extent of the reduction would depend on the extent to which individuals take early access to the funds, which in turn would depend on the magnitude of the penalty for early withdrawal, as well as on any additional taxes imposed on the withdrawal. Because it is assumed that IPA contributions would be mandatory, any access to the account balances would result in dissaving. This result contrasts with IRAs, in which contributions are voluntary. Some have argued that access to IRA balances may actually increase national savings because taxpayers will be more willing to make the IRA contributions if they have access to the balances.
The issue of early access to the funds, with or without penalty, is of critical importance if IPAs would be coordinated with Social Security benefits. If, for example, Social Security benefits were reduced as a result of withdrawals from IPAs in retirement, there would be an incentive for individuals to access their IPA funds early, prior to retirement, so that they would be eligible for full Social Security benefits upon retirement. To the extent IPA funds were withdrawn early in order to avoid the Social Security benefit reduction, and spent rather than saved, the proposal would have less of a positive impact on national saving. For further discussion of integrating Social Security benefits with IPA withdrawals, see Part IV.B.3 below and and Part III.E.4 above.
3. Funding and tax treatment of IPAs; coordination of IPAs with Social Security
The decisions regarding the source of funding for the IPAs and the taxation (including the offset of Social Security benefits) of the IPAs will ultimately determine the distributional impact, both within and across generations, of the establishment of a system of IPAs.
Funding of accounts
As described above, the IPA accounts could be funded in a variety of ways. The most commonly discussed funding methods have been the dedication of a portion of payroll taxes to IPAs, funding an amount equal to a portion of payroll out of general revenues, or "use of the surplus." Use of the projected surpluses is equivalent to the use of general tax revenues to fund the accounts. Tracing the source of the surpluses to payroll taxes, or income taxes, or corporate taxes, or excise taxes, etc., is not an easy task, but the revenues that create the projected surpluses nonetheless represent a tax burden that ultimately falls on individuals.
While various administrative mechanisms for funding IPAs have been discussed, the important economic question concerns the ultimate source of the funds--that is, who bears the burden of any taxes used to finance the accounts. Setting aside the issue of the tax treatment of account withdrawals and any Social Security interaction, any approach that does not require funding from a taxpayer's own after-tax dollars, or that does not fund an individual's account in direct proportion to that individual's tax payments, would change the progressivity of the tax and benefit system.(38) In this regard, it is important to note that the funding of IPAs in direct proportion to an individual's burden from a new tax is equivalent to funding them from a taxpayer's present-law after-tax income.(39) Similarly, if IPAs could be funded from projected surplus revenues in direct proportion to each individual's contribution to such surpluses, this too would be the economic equivalent of funding IPAs from after-tax dollars while maintaining the same progressivity of taxes that fund other government benefits.
Proposals that are based on a tax on payroll would not alter present-law progressivity provided that IPAs are funded in direct proportion to the tax. However, if additional funds were directed to lower earners, as some proposals have suggested, the tax and benefit system would be made more progressive. Similarly, if general revenues were used to fund such accounts, the tax and benefit system would be more progressive unless such accounts were funded proportionally to each individual's general tax burden (primarily Federal income taxes). The use of the projected surpluses to fund the accounts would not, as mentioned above, mean that tax revenues are not being used to fund the accounts. Funding the accounts with the projected surpluses would mean that tax revenues will have to be higher than they otherwise would have to be in the absence of IPAs funded by government revenues. The distributional impact of funding the accounts from the projected surpluses depends on who bears the burden of the taxes that produce the projected surpluses. As a practical matter, once a proposal is adopted that draws on the funds that would have created the surplus, there is no longer a projected surplus. At that point, there would simply be a policy in place to fund IPAs from tax revenues, the precise burden of which would evolve over time as future Congresses continue to alter tax policies.
An alternative way to fund IPAs would be to require that individuals contribute to IPAs from their after-tax dollars. This approach would be the economic equivalent of establishing a tax on such individuals and immediately returning the money to them with the requirement that it fund an IPA account. For example, a new payroll tax of two percent could be imposed on individuals; the tax could be collected as is the current payroll tax, and transferred to an individual's IPA. With respect to this funding mechanism, there would be no change in the net taxes/benefits that an individual experiences from government policies, provided that IPAs receive tax treatment similar to other taxpayer investments made from their own after-tax resources.
Finally, the IPAs could be funded with pre-tax dollars. For example, a new payroll tax of two percent could be imposed and transferred to an individual's IPA. However, unlike the present-law employee share of the payroll tax, a Federal income tax deduction would be allowed for the amount of the tax. Such funding would be the equivalent of the present-law funding of deductible IRAs or section 401(k) plans.
Taxation of accounts
The establishment of IPAs raises important questions concerning the appropriate tax treatment of such accounts. The choice of tax treatment will affect the overall progressivity of the Federal tax system and the intergenerational distribution of tax burdens. Depending on what policy objectives are being pursued, different tax treatments would be appropriate. A given tax treatment on the distribution of funds from the IPA would have different implications depending on the source of funding of the IPA.
Withdrawals from an IPA could be taxed in a variety of ways. No particular way can be said to be appropriate, but different approaches have different parallels to present law. If we assume that the accounts are effectively funded from a taxpayer's after-tax dollars, then the tax treatments most closely resembling aspects of the present law treatment of investment income would be (1) tax the earnings and any capital gain realizations on an annual basis at ordinary income rates, or capital gains rates, as appropriate; (2) tax the earnings and any capital gains upon withdrawal at ordinary income tax rates; or (3) impose no taxes. The first approach would tax the investment income in the same manner that a taxpayer's ordinary after-tax investments would be taxed--i.e. the same way that any investments made from after tax dollars invested in stocks, bonds, real estate, etc., would be taxed. The second approach would be equivalent to taxing the earnings and capital gains in the same manner that nondeductible IRAs are currently treated. That is, deferral on the earnings and capital gains would be allowed, but upon withdrawal all investment income would be taxed at ordinary rates. The third approach would be similar to the treatment afforded Roth IRAs under present law.
If the accounts were effectively funded from a taxpayer's pre-tax dollars, the only tax treatment analogous to present law would be similar to that of (2) above, but with the inclusion of a tax on the principal withdrawal as well. Such taxation would be analogous to the present-law treatment of deductible IRAs or of section 401(k) plans.
Finally, it is possible that the funding for some of the accounts is, in whole or in part, a transfer payment.(40) If an individual's IPA is funded out of someone else's tax dollars, that expenditure would generally be considered a transfer payment. A comprehensive income tax would generally treat the IPA transfer as income, and tax it accordingly. If it were exempt from income taxes initially, and distributions, including the distributions of principal, were subsequently taxed, the IRA would be given tax treatment analogous to that of a deductible IRA or a section 401(k) plan. Alternatively, if the IRA were taxed as income upon receipt of the transfer, the implications of the subsequent tax would be the same as that for investment income from after-tax dollars, as is laid out in points (1) through (3) above.
Interaction with Social Security
IPAs could interact with Social Security in a variety of ways. On the funding side, some proposals have discussed using a portion of the current payroll taxes to fund the accounts. Such a use of the payroll taxes would exacerbate the projected financial shortfall in meeting future Social Security obligations unless countervailing measures were taken. One such countervailing measure would be to reduce present-law Social Security benefits by some amount which is conditioned on the ultimate accumulations in an individual's IPA. Present law Social Security benefits could be reduced in such a manner regardless of how IPAs were originally funded - i.e., whether they were funded out of a portion of current payroll taxes or not. Any such reduction in Social Security benefits would be the economic equivalent of a tax.
To understand the interaction of IPAs with Social Security as a tax, consider the following example. Take the case of an individual with $100 in wage income in his working years on which $20 is paid in taxes. His promised Social Security benefits are $20 in his retirement years. If the taxpayer does no saving, he would consume $80 in his working life, and $20 in Social Security benefits during retirement. If the taxpayer has the option to contribute $2 from his after-tax income to a Roth IRA(41), which is assumed to grow to $5 by retirement, the taxpayer can choose to reduce consumption in his working life to $78 in exchange for raising his retirement income to $25. This can be taken as a simplistic representation of present law.
Now consider the addition of a system of IPAs in which the accumulations result in a partial reduction in Social Security benefits, say 50 cents on the dollar. We consider as the base case the situation in which the individual is required to fund the IPA out of his own after tax dollars. Such funding would imply no changes to the system of taxes in place to fund other government programs, and thus no changes to the progressivity of the tax system. Taking the case of the individual above who does not chose to contribute to a Roth IRA, if a $2 IPA is funded from his after-tax dollars(42), the individual's consumption during his working life would be restricted to $78. The IPA is assumed to be invested in the same assets that the Roth IRA was in the previous example, and thus grows to $5 at retirement. As was previously discussed, if no taxes are imposed on the $5 IPA withdrawal, the IPA would be the equivalent of a mandatory Roth IRA. If the individual's previously-promised Social Security benefits are reduced as a result of the IPA withdrawal, it is clear that his retirement consumption is restricted relative to present law, i.e. his taxes have been increased. If the taxpayer loses 50 cents for each dollar of IPA withdrawal, the individual's Social Security benefits would fall by $2.50, to $17.50. The individual's retirement income is thus $22.50 ($17.50 from Social Security plus $5 in the IPA), assuming no other explicit or implicit taxes on the IPA accumulations. Relative to the person who contributes the $2 to a Roth IRA under present law, the taxpayer has the same consumption of $78 during his working years, but his retirement income is $2.50 less. If other federal taxes are imposed on the IPA, such individual's retirement consumption would be further restricted.
Relative to the Roth IRA treatment, the individual is subject to a large effective tax rate by virtue of the Social Security benefit reduction. In this example, of the $3 gain in the value of the IPA, $2.50, or 83 percent, is effectively taxed away by the reduction in Social Security benefits. The reduction in Social Security benefits means that the individual is required to finance a larger share of his own retirement income relative to present law. Because Social Security has historically been financed on a pay-as-you-go basis, the reduction in Social Security benefits implies that lower payroll taxes on the next generation of workers would be required to meet the Social Security benefits of the initial generation of workers that retires with IPAs. Hence, an implicit tax burden of future workers has been shifted to the present generation of workers to the extent that Social Security benefits are reduced as a result of IPA accumulations. In essence, the initial generation of workers that would retire with IPAs is required to pre-fund a portion of its own Social Security benefits, while continuing to pay the taxes necessary to support current retirees. The subsequent generation of workers would also be required to prefund a portion of its Social Security benefits, but this generation would be absolved of financing the full Social Security benefits of the generation of workers that preceded them, since this preceding generation would have contributed to IPAs themselves.
Any interaction of Social Security benefits with IPA withdrawals greatly complicates the other design features of the IPA system. First, if the IPAs are to be effectively highly taxed as a result of the interaction with Social Security benefits, it is clear that they would have to be made mandatory, as other saving options would be more desirable to the individual. Early withdrawals from IPAs would also have to be closely scrutinized. If withdrawals are permitted to be made prior to retirement for certain purposes, it is likely that many people would make such withdrawals in order to avoid the effective tax on their Social Security benefits in the future. To the extent such withdrawals are made to avoid a Social Security benefit reduction, greater outlays of Social Security would result when such individuals do retire, and to the extent the IPAs were meant to reduce future Social Security outlays, they will have been less successful as a result of the early withdrawals.
4. Account investment issues
In general
There are several important economic issues to consider with respect to investment of IPA funds. Most of these relate to restrictions on investments that might be desirable to impose in order to meet the intended social goals of establishing IPAs.
A commonly discussed restriction concerns requiring that the accounts be managed by designated professional money managers offering funds satisfying certain criteria, such as investing in a diversified selection of stocks or bonds. The Federal Thrift Savings Plan (discussed in Part II.C above), which offers a limited selection of funds and restricts trading activity, is often cited as a model of how IPAs might work. A restriction on the type of fund that IPAs might be invested in that is often advocated is that the fund be designed to mimic an established index of stocks or bonds, such as the Standard & Poors 500. There are two primary reasons for advocating such a restriction. First, the companies in the index are 500 of the largest U.S. corporations, representing over two-thirds of the total U.S. market capitalization, and are thus likely to provide stable returns over the long term. Second, by investing in an index of stocks or bonds, trading activity expenses are kept to a minimum, ensuring that a larger share of accounts is ultimately available for retirement consumption.(43) Such expenses can be quite substantial over the long term. For example, a $100 invested in a fund that generates a 10 percent annual pre-expense return will be worth $1,327 after 30 years if the fund incurs annual expenses equal to one percent of capital under management. The same fund incurring a two percent expense charge would be worth only $1,006 after 30 years. Clearly, for a given contribution, more funds will be available to finance retirement consumption the lower are expenses in managing the account.
Another area in which restrictions might be imposed is in the allocation of investments across eligible classes of investment--that is, the investment mix of stocks versus bonds, or other possible investments. An all-stock allocation is expected to yield higher returns, but also to be accompanied by higher risk. Conversely, an all-bond investment is expected to produce lower returns, but is expected to produce its expected return with more certainty than a stock investment. This raises the questions of whether particular allocations of investments should be mandated. Some would argue that requiring a particular mix of stocks and bonds would yield the desirable risk/return profile. However, a given allocation is not likely to be appropriate for all individuals. Older individuals might wish to pursue a more conservative approach, owning more bonds, as they are nearer to retirement and have greater need for certainty in their asset values. Younger individuals might prefer a more aggressive approach more heavily weighted in stocks, in hopes of gaining a higher return, but knowing that if the investments should fail they have a greater share of their working lives ahead of them to make up for the losses. Additionally, an individual's desired allocation might depend on what assets are held outside of the IPA. If an individual has substantial stock ownership outside of the IPA, such an individual might prefer a larger share of bonds in their IPA. In general, individuals attitude towards risk will vary, and hence portfolio allocations should be expected to vary across individuals.
If any individual discretion would be allowed in the investment of IPA funds, even if such discretion is merely a matter of the investment mix across a restricted set of designated professionally managed funds, the issue arises of how individual account holders will acquire the necessary information to make informed choices. Such education would need to include education as to the expected risk and return of particular investments, as well as perhaps advice on desirable investment mixes across stocks and bonds for account holders of particular ages. Such educational efforts will add to the expense of establishing and maintaining IPAs, though the regulation and disclosure requirements currently imposed on the mutual fund industry would provide a guide for, and give some indication of the likely expense of, certain of the investor education efforts. In a broad based IPA system, certain of the account holders are likely to have less financial education that the typical mutual fund holder, and greater educational efforts might be required for such investors to learn to make informed investment choices.
Capital market and investment distortions
Any system of IPAs that requires investments in particular assets has the potential to distort the free flow of investment capital, especially if IPAs ultimately contain a large share of private savings. For example, a rule requiring only stock investments in a given index might make it easier for the firms in that index to raise investment capital relative to firms not in the index, and thus lead to a different mix of aggregate investment activity than would otherwise prevail in the absence of such requirements. If the designated index contains relatively large stocks, such companies might be given an additional advantage, at least during the start-up period of IPA formation, in raising capital, leading to a greater concentration of economic activity in larger firms. Large mandated purchases of particular stocks are likely to bid up the value of such stocks relative to other stocks, and lower the expected return on future purchases of those stocks. A parallel concern arises when the assets in the IPA are sold. While during the start-up phase of IPA establishment there would be more purchases than sales of the stocks in the index, when the system is fully phased in there would be times when sales exceed purchases, and vice versa. If, for example, annuitization of IPA balances is required at age 65, mandatory sales of the aggregate IPA stocks in the index might at times exceed mandatory purchases in younger workers' IPAs, leading to downward pressure on the valuations of the stocks in the index. As demographics shift over time, this situation could reverse itself repeatedly, with certain generations buying at times when net IPA purchases are positive, pushing up prices, and selling when net IPA purchases are negative, pushing down prices.
In general, to the extent that a system of IPAs prescribes investment in established channels, the availability of financing for many small businesses, or potential small businesses, will to some degree be constrained. For example, as the most readily available source of investment funds for many small businesses is the proprietor's own savings, any system of mandatory individual accounts with constraints on investment choice will reduce the amount of savings available to finance one's own business activity. To the extent that this would limit entrepreneurial activity, long run economic growth could be impaired.
In addition to their potential to distort investment activity as a result of restrictions on available investments, IPAs could distort investment activity if the investment performance of the funds is in any way guaranteed. Such guarantees could include certain interactions of the IPA outflows with Social Security benefits. If the performance of one's IPA is in any way guaranteed, an incentive is created to pursue higher-risk investments. A government guarantee of a fund's performance would limit the downsize risk to the individual, and lead to increased risk taking. While it could be argued that to some degree a government stimulus to risk taking would be desirable in order to improve aggregate average investment returns (assuming such investment possibilities exist with higher than average returns but which are not undertaken due to the risk), a stimulus would go too far if it resulted in a situation where the government was more of a partner in an investor's losses than in the gains.(44) For example, consider a case where the government guaranteed that your IPA plus a lump sum Social Security benefit would be worth at least $10,000 at retirement. Now consider an individual on the cusp of retirement with $10,000 in an IPA, with two investment possibilities. One will yield either a $1,000 or a $3,000 return with equal probability, for an expected average return of $2,000. The other will yield either a loss of $5,000 or a gain of $5,000 with equal probability, for an expected average return of $0. Thus the former investment has both a higher expected value and is less risky in the sense that the return will be close to its expected value.(45) To the typical risk averse or risk-neutral individual, it is clearly the better investment. To the economy as a whole, it is clearly the best investment as, across multiple individuals, it promises an average 20 percent return, whereas the other investment promises a 0 percent return, which will lead to no economic growth. Now, if the government guarantees that the IPA plus a lump sum Social Security benefit will be worth at least $10,000, it effectively is guaranteeing the replacement of all of the losses from the investment. Thus, to the individual involved, the risky investment actually has no downside risk, since the government will make up all the losses. Thus, the expected private return becomes $2,500 (� times $0 + � times $5,000) even though the true social expected return is $0. This expected return is now greater than the preferred investment, and thus the incentives will induce some to make this investment, even though from society's standpoint such investment is not desirable. While the above example is recognized to be extreme, it illustrates a problem that will exist to some degree to the extent that the government guarantees the performance of a portfolio where the manager of the portfolio can choose among assets of varying degrees of risk and expected return. On the other hand, providing no guarantee of at least a minimal Social Security benefit raises other social policy issues. Without a minimal benefit, some individuals will not have sufficient retirement income.
V. BACKGROUND INFORMATION RELATING TO
RETIREMENT SAVINGS
A. Economic Status of the Elderly
Sources of retirement income
Social Security is the largest source of retirement income (39 percent in 1996), followed by wage and salary earnings (22 percent in 1996), employee pensions, annuities, and alimony (18 percent in 1996), and income from assets (17 percent in 1996).(46) Figure 1 shows this breakdown of sources of retirement income.
Many researchers have attempted to measure whether individuals have adequate savings for retirement. A common measure of retirement savings adequacy is called the replacement rate, which is defined as the ratio of the individual's retirement income to income during the individual's working years. A replacement rate of 100 percent means that the person's income during retirement is equal to their income during working years.
The issue of what replacement rate should be considered adequate depends on a number of factors. There are a number of reasons that a replacement rate of 100 percent may not be optimal. First, people may desire to have more income during their working years because some of that income is saved for retirement. If people choose to have constant consumption over time, they save during their working years and dissave during retirement. Thus, if a household has a 10-percent saving rate during their working years, a 90-percent replacement rate would be sufficient for the household to maintain constant consumption in retirement. Second, most elderly own their own homes. In 1996, more than 81 percent of those households headed by an individual aged 65 to 74 and 75.3 percent of households headed by an individual age 75 or over owned their own homes.(47) Most of these households have paid off their mortgages. Only 25 percent of households headed by a person aged 65 to 74 years old had any mortgage or home equity debt. Among households headed by a person aged 75 years or older, only seven percent had any mortgage or home equity debt.(48) Thus, most elderly receive housing without incurring any expenses beyond maintenance, property taxes, insurance, and utilities, whereas during their working years, these individuals were likely to have been making mortgage payments. Third, few elderly households care for children; therefore, household expenses are likely to be lower. Fourth, the elderly are generally covered by Medicare, which provides insurance against large medical expenses and pays for most medical expenditures. Fifth, retirement income generally bears a lower tax burden than does wage income. Salaries and wages are subject to the payroll tax. Retirement benefits are not. Also, Social Security benefits, which represent the major source of retirement income, are largely untaxed.(49) Thus, Social Security benefits can be smaller than income earned during the working years and still provide the same after-tax income. For the lowest income groups, this effect is not large since earned income is subject to the payroll tax, but may not be subject to the income tax.
These arguments suggest that the appropriate replacement rate for the elderly to have adequate retirement income is less than 100 percent. However, some factors may suggest that the replacement rate should be higher than 100 percent. First, although the elderly are covered by Medicare, they are also more likely to incur large medical expenses (e.g., expenses for prescription drugs) which may not be completely covered by Medicare. Similarly, Medicare generally does not cover nursing home care or the costs of care in other long-term care facilities, and only those elderly poor enough to receive Medicaid or eligible through veterans' assistance will have coverage for such benefits. Second, the elderly may find it necessary to hire service providers for tasks that younger households provide for themselves. For example, elderly households may contract for home repair work that younger households self-provide.
Replacement rates for Social Security and pension income for retired workers commonly are calculated using two methods. The first method calculates the ratio of Social Security and pension benefits relative to a worker's highest career earnings.(50) Career high earnings overstate average earnings. The second method calculates benefits relative to the average earnings in the five years preceding retirement.(51) However, for many workers, their peak earning years are not the years immediately prior to retirement. Consequently, earnings during the five years preceding retirement may understate average earnings. Thus, these two replacement rates may be seen as upper and lower bounds of estimates of the replacement of average career earnings. These replacement rates measure the replacement of income through retirement benefits, and do not include any income earned during retirement or any income from savings. For individuals who retired in the mid to late 1980s, such calculates indicate that Social Security and pension benefits replace roughly 33 percent of the career high earnings and 50 percent of earnings over the last five years for individuals. When spousal benefits are taken into account, replacement rates are slightly higher, averaging 30 to 33 percent of highest earnings, but 60 to 70 percent of last five-year earnings. These calculations also demonstrate that replacement rates are highest for the poor. For the lowest income quartile, individual replacement rates varied between 34 and 39 percent of highest earnings, and 72 to 94 percent of last earnings.(52)
Analysis of more recent retirees suggests similar outcomes. A recent study calculated replacement rates for families with at least one individual between the ages 52 and 61 in 1992. Such individuals generally would be expected to retire between 1993 and 2006.(53) This study attempted to account for all sources of non-earnings income of retiree households: social security benefits; pension benefits; private saving; equity in personal residences; and equity in business assets. The authors calculate that, in 1992, prior to actual retirement, these households, on average, held assets sufficient to produce income in retirement that would replace 86 percent of their pre-retirement income. For households in the median 10 percent of the population (i.e., those with incomes between the 45th and 55th percentiles of the income distribution), the replacement rate was 97 percent. The bottom 10 percent of earners had the highest replacement rates and the top five percent of earners had the lowest replacement rates.(54) However, other analysts reviewing the same data suggest a less optimistic outlook. They conclude that, projecting continued accumulation of pension benefits, continued accumulation of earnings on existing financial assets, and continued reduction in mortgage debt prior to retirement, if the median household intended to retire at age 62, it would need to save 16 percent of future annual pre-tax earnings to preserve pre-retirement consumption. The authors observe that a saving rate of 16 percent exceeds the median household's observed saving rate of approximately 5 percent.(55)
Finally, Social Security benefits have increased over time. Social Security benefits relative to the income of the elderly have increased substantially over the past 40 years. On the other hand, a current concern is whether the Federal Government will be able to continue paying the promised benefits. If benefits were to be reduced for future retirees, the replacement rates reported above would overstate likely future replacement rates.
Poverty
Another method used to examine the economic status of the elderly is to compare their rates of poverty to those of the general population. Poverty among the elderly has declined dramatically over the last 30 years, from over 35 percent in 1959 to 12.6 percent in 1985. By 1985, the poverty rate of the elderly was less than the poverty rate of the general population. In 1996, the poverty rate of the elderly was 10.8 percent and the poverty rate of elderly persons living in families (with a spouse or children) was 5.6 percent, lower than for any other group.(56) The major explanation for this decline in poverty is the increase in Social Security benefits and coverage described above.
B. Expected Retirement Income and Needs of Current Workers
The above discussion demonstrates that, as a group, the elderly are as well off as the rest of society, indicating that savings were adequate given current Social Security and current pension benefits. However, to determine whether the savings of current workers are enough to provide adequate retirement income, it is necessary to examine how this group might differ from current retirees.
Social Security and employer-provided pension plan coverage
Social Security coverage.--Because Social Security coverage of workers has increased over time,(57) and because the labor force participation of women has also been increasing, current workers are more likely to be covered by Social Security than current retirees. In 1996, out of more than 150 million workers, 6.6 million workers were not in employment covered by Social Security. Most of these were Federal, State, and local government employees. The percentage of uncovered workers will further decrease in the future as all Federal employees hired after 1983 are covered and beginning in 1991 all State and local employees who are not members of a public retirement system were mandatorily covered under Social Security.
Current pension coverage.--Similarly, pension coverage of current workers is also substantially larger than that of current retirees.(58) The term "covered," as used here, means that an employee is accruing benefits in an employer pension or other retirement plan. The best current comprehensive evidence on pension coverage comes from a supplement to the April 1993 Current Population Survey conducted by the Bureau of the Census. The data referred to below come from that survey unless otherwise noted.
As of April 1993, 63 percent of full-time wage and salary workers employed in the private sector reported that they worked in firms with an employer-sponsored pension plan. Half
of the full-time wage and salary workers employed in the private sector were covered by an employer-sponsored pension plan. Most of these workers were covered by single defined
benefit or defined contribution plans (23 percent), and another 10 percent had both a defined benefit or defined contribution and a 401(k) type contributory plan (see Table 5).(59) For another 17 percent, the 401(k) type plan was their only retirement plan.
Pension coverage varies substantially among full-time, privately employed workers. Differences depend on the age of the worker, job earnings, the industry of employment, and the size of the firm. Younger workers are much less likely to be covered by a pension plan than middle aged and older workers. Coverage rates rise steadily from 21 percent for those under age 25 to about 60 percent for those between ages 40 and 60 before falling off somewhat. This pattern holds for both men and women. However, the increase in coverage for middle aged men is slightly larger than the increase for middle aged women (see Table 6).
Higher paying jobs are more likely to offer pensions. Just 8 percent of full-time private wage and salary workers earning less than $10,000 per year in 1993 were covered under an employer-sponsored plan compared to 81 percent of those earning $50,000 or more (see Table 7). Coverage may be higher for higher paying jobs because of the greater value of the pension tax benefits to workers in higher tax brackets and because of the declining replacement rate of Social Security at higher earnings levels.
Significant differences in coverage also are apparent between full-time private wage and salary workers and other wage and salary workers. Coverage is much lower among part-time workers and much higher among public employees. Among part-time, private wage and salary workers, 12 percent are covered. Seventy-seven percent of public sector wage and salary workers are covered including 85 percent of those who are full-time workers (see Table 8).
Coverage is much lower for smaller firms. Smaller firms are less likely to offer comprehensive fringe benefit packages as part of total compensation. Only 13 percent of full-time private wage and salary workers in firms with fewer than 10 employees are covered. The rate rises with employer size but does not reach 50 percent (the average across all firm sizes) until firms have 100 or more employees. (See Table 9)
The data above report pension coverage of individuals. When assessing the effectiveness of pensions in providing retirement income, it is more relevant to think of pension coverage of households. Thus, if both the husband and wife work and only the wife accrues pension benefits, the tables above would record that 50 percent of individuals are covered by a pension. However, in this example, 100 percent of the households (the married couple) receive pension retirement benefits. A recent study highlights the importance of this distinction. It found that in 1992, half of all individuals aged 51 to 61, that, is on the verge of retirement, had rights to a pension from a current or prior job, but two-thirds of all households with at least one member aged 51 to 61 had vested rights to a pension from a current or prior job.(60)
Trends in pension coverage.-- At the outset of World War II, private employer pensions were offered by about 12,000 firms. Pensions spread rapidly during and after the war, encouraged by high marginal tax rates and wartime wage controls that exempted pension benefits. By 1972, when the first comprehensive survey was undertaken, 48 percent of full-time private employees were covered. Subsequent surveys found that coverage reached 50 percent in 1979, but by 1983 had fallen back to 48 percent. The decline continued in the 1980s, reaching 46 percent in 1988.(61) By 1993, coverage had returned to 50 percent.
The decline in coverage in the 1980s was concentrated among younger men. The coverage rate among older men has fallen less dramatically, and among women it has risen at some ages and fallen at others.
The decline in pension coverage has occurred at the same time that employers have been shifting from defined benefit plans. Defined benefit plans provided basic plan coverage for 87 percent of private wage and salary workers in 1975.(62) This proportion dropped to 83 percent by 1980 and to 71 percent by 1985. This shifting composition has largely been the result of rapid growth in primary defined contribution plans. Employee stock ownership plans and 401(k) plans have been among the most rapidly growing defined contribution plans.
Figures 2 and 3 show the net acquisition of assets by defined benefit and defined contribution plans for the period 1986 through 1997. Figure 2 shows that there has been little net acquisition of assets by defined benefit plans over the past 12 years. Three factors may have produced this outcome. First, as mentioned above, a number of employers have been shifting from defined benefit plans to defined contribution plans, thus halting contributions to defined benefit plans and, in some cases, transferring benefits from defined benefit plans to defined contribution plans. Second, because defined benefit plans generally have been in place longer, more of these plans have a significant number of beneficiaries receiving payouts from the plans. Payouts necessitate liquidation of some plan assets. Third, in recent years increases in the market value of equities may have caused plan funding levels to rise, necessitating smaller contributions to satisfy projected funding requirements. As Figure 3 shows, defined contribution plans have been accumulating assets in consistently greater amounts over the past 12 years. Some of the asset growth results from transfers from defined benefit plans and some is a result of the youth of the plans resulting in the plans covering few individuals who are presently retired, with most of the plan participants being in the accumulation phase.
Figures 4 and 5 utilize data from the Federal Reserve Board's Flow of Funds Accounts to show the value of assets accumulated in defined benefit and defined contribution pension plans. At the end of 1997, the value of assets in each type of plan was equal to approximately $1.8 trillion. The figures also document the rapid accumulation in assets in defined contribution plans compared to that of defined benefit plans over the past 10 years.
Personal saving
Aggregate saving.--Although coverage by pensions and Social Security is expected to be higher for current workers than it is for current retirees, the saving rate of current workers may be lower than the rate at which current retirees saved during their working lives. This would imply that although two sources of retirement income, Social Security and pension benefits, are expected to be higher for current workers, another source, income from savings, may be lower.
The measure of personal saving used in the National Income and Product Accounts attributes all corporate pension contributions and earnings to the household sector.(63) Thus, the increased pension coverage is already included in the measure of household saving. Tables 10 and 11 and Figure 6, show that personal saving has been declining over the past 15 years. Private saving, which includes the saving of business, and which may provide a better measure of total households saving since businesses are ultimately owned by household, exhibits the same downward trend. Thus, the saving of the current generation of workers for their retirement seems to be low relative to the past. On the other hand, the National Income and Product Accounts measures of saving measure only cash flows not consumed. The purpose of saving for retirement is to accumulate wealth which can be drawn upon in retirement. If, as in the past few years, the market value of assets increases, adequate wealth accumulation may be attained with relatively low saving rates.
Retirement saving of individuals.--It is difficult to determine how much saving outside of qualified plans is "retirement saving." Contributions to IRAs represent one measure of such non-pension plan retirement saving. Assets within IRAs have grown substantially over the past 10 years. Figure 7 below shows that IRA balances, approximately $1.6 trillion in 1996, are nearly equal in size to the asset balances in both defined benefit and defined contribution plans. (See Figures 4 and 5 above.)
The growth of these balances is impressive in its magnitude, particularly given the relatively modest contributions of recent years. Table 12, below, reports IRA contributions between 1979 and 1996. Deductible IRAs have been very popular with taxpayers. As Table 12 reports, contributions to IRAs increased significantly when eligibility restrictions were eliminated in 1982. At the peak in 1985, over $38 billion was contributed to IRAs. This represented almost 20 percent of personal saving for that year.
In addition to annual contributions, the current value of IRA balances, as reported in Figure 7, is comprised of balances rolled over into IRAs from qualified plans and increases in the market value of IRA investments.
As with pension coverage, IRA coverage is not universal. Tables 13 and 14 summarize information on IRA participation in 1985 and 1996. Some have expressed concern about the distribution of taxpayers who contribute to IRAs. The concern is two-fold. First, unequal participation may lead to some taxpayers having accumulated substantial wealth for retirement while other taxpayers have accumulated little wealth. Second, because IRA contributions receive preferential tax treatment, the distribution of the tax expenditure may be viewed as inequitable. In 1985, 71 percent of all returns reporting IRA contributions had adjusted gross income ("AGI") below $50,000, and 29 percent had AGI of $50,000 or above. However, taxpayers with AGI of $50,000 or above represented only 8 percent of all returns eligible for IRAs. Thus, although many lower-income individuals contributed to IRAs, most did not, whereas most taxpayers with AGI of $50,000 or above did contribute when eligible. Taxpayers with AGI of $50,000 or above were more than four times as likely to contribute to an IRA than were taxpayers with AGI below $50,000--61.8 percent of eligible returns with AGI of $50,000 or above reported contributions to an IRA, while only 13.8 percent of eligible returns with AGI below $50,000 reported IRA contributions. On the other hand, the data for 1985 or 1996 represent one-year snapshots of IRA contributions. If the earning power of young individuals increases over time, an individual who did not contribute to an IRA when earning $20,000 per year may later contribute when earning $40,000 per year.
Higher income taxpayers made larger contributions as well. Taxpayers with AGI of $50,000 or more constituted approximately 29 percent of all IRA contributors in 1985, but accounted for more than 35 percent of IRA contributions. In 1996, taxpayers with AGI of $50,000 or more constituted approximately 25 percent of all IRA contributors, but accounted for approximately 34 percent of IRA contributions.
Because the value of the IRA is the effective exemption of the earnings from tax, the higher a taxpayer's marginal tax rate, the more valuable the ability to invest through an IRA. Because people in higher income classes generally have higher tax rates, the value of their IRA is larger than the value of IRAs for taxpayers in lower income classes. However, the value of the IRA depends on tax rates throughout the period the IRA is held, and not just the marginal tax rate in the year the contribution is made.
It is too soon to assess the effects that the Taxpayer Relief Act of 1997 may have on IRA participation and retirement asset accumulation. Tables 15a and 15b, below, present the Joint Committee on Taxation staff estimates of the eligibility of taxpayers to make deductible IRA contributions under present law for 1999. The percentage of taxpayers eligible to make deductible IRA contributions differs modestly by filing status. Among married couples filing joint returns, 58 percent are eligible for up to a $4,000 deductible contribution, an additional 15 percent are eligible for up to a $2,000 deductible contribution, and approximately 20 percent are ineligible to make a deductible contribution. Among single filers and head of household filers, only 14 percent are ineligible to make a deductible contribution.
Other authors have noted that even the taxpayers with low income who did contribute to IRAs owned more financial assets than other low-income taxpayers and that, therefore, IRA contributors may not be representative of taxpayers in general. Table 16 presents information on the assets of households with IRAs compared to the assets of households without IRAs. For each income category, the table reports the gross financial asset holdings and non-retirement asset holdings of the median (50th percentile) household.(64) As the table details, families with IRAs have larger holdings of financial assets than do families without IRAs. However, it is also the case that families with IRAs have larger holdings of financial assets than do families without IRAs even when all IRA and pension assets are excluded. Part of the reason that IRA contributors have larger holdings of assets than noncontributors is that contributors to IRAs tend to be older than noncontributors, and older taxpayers have been accumulating assets longer.
Estimates of saving rate adequacy.--The Congressional Budget Office ("CBO") reported that while the saving rate of current workers appears low relative to the past, this may not imply that the level of savings is inadequate for retirement. That CBO study concludes that the so-called "baby boom" generation appears to be accumulating assets at a rate equivalent to that of their parents who are currently retired. The CBO concludes that the continued increase in real wages, the fact that baby boomers are more highly educated than their parents, and the increased participation of women in the labor force portend "increases in household incomes of baby boomers in retirement."(65) Some have criticized the conclusion of this study as too optimistic. Critiques note that finding that baby boomers have accumulated approximately the same amount of assets as their parents at a similar age does not bode well for retirement income. Having the same amount of assets would imply only the potential for the same amount of income as experienced by current retirees, and as incomes grow this would imply future retirees would be less well off compared to the rest of society than are current retirees. Critics also note that current retirees benefitted from increases in Social Security benefits and unexpected capital gains on housing that the baby boomers may not reasonably expect to experience.(66) All studies of this question have emphasized the important differences within the so-called baby boom generation. Most studies note that those with the least education appear to be least well prepared for retirement in terms of accumulating private assets. Some studies suggest that the first cohort (i.e., those born 1946-1950) of the baby boom generation is likely to be better prepared for retirement than the last cohort (i.e., those born 1960-1964) of the baby boom generation.(67)
C. Increased Retirement Costs
Finally, it is possible that the need for retirement income is increasing over time. Increases in life expectancies and trends toward earlier retirement increase the number of years in retirement and therefore increase the need for saving. Furthermore, the normal retirement age for Social Security was changed in 1983. For those born in 1937 or earlier, the normal retirement age is 65 years old. Thus, in 1999, the normal retirement for Social Security (the age at which retirees receive full benefits) is 65. For those individuals born in 1960 or later, the normal retirement age is 67 years old. That is, by 2027, the normal retirement age will be 67 years. If the increase in the normal retirement age means that individuals will be working more years, then current saving need not adjust. However, if the historical trend toward earlier retirement continues, then the increase in normal retirement age for receipt of full Social Security benefits means that individuals should increase their retirement saving.
Similarly, increased life expectancies and rapid medical cost inflation increase the probability of large medical expenses. Out-of-pocket medical expenditures for the elderly have been steadily increasing over the last 15 years. Also, many people have noted that the probability of an individual requiring long-term care some time in their lifetime has been increasing.
A. Developed Countries
1. United Kingdom(68)
The British social security system is comprised of two tiers. The first tier consists of a "Basic State Pension." The basic state pension does not depend upon the beneficiary's earning history. Instead it is set at an amount estimated to be somewhat above a subsistence level. In 1997, the weekly value of the basic state pension was approximately $100.(69) To qualify for the full basic state pension, the beneficiary must have worked, and paid payroll taxes, for 90 percent of their working lives. Workers failing to exceed the 90 percent threshold receive a proportionately reduced basic state pension. Since 1975, a proportional payroll tax has funded the benefits paid under the basic state pension.
The second tier of the British social security system is the "state earnings related pension scheme" ("SERPS"). A worker's earnings determine the SERPS benefit. Workers may choose to receive their SERPS benefit from the government's SERPS plan or by "contracting out" to participate in a qualified employer pension plan or an individual retirement savings account.
The government's SERPS benefit is based on the beneficiary's weekly earnings. There is a lower weekly earnings limit below which the employee accrues no benefits. There also is an upper weekly earnings limit above which the employee accrues no additional benefits. Employees pay two percent of earnings up to the lower earnings limit and 10 percent of earnings between the lower and upper earnings limits. Employers also must make earnings-related contributions to the National Insurance Fund at rates that rise from three to 10 percent and are not capped.(70)
A worker may elect to be covered under an approved company plan in lieu of the government's plan. The company plan may be either a defined benefit plan which offers benefits comparable to the government SERPS benefit, or a defined contribution plan. Employer and employee contributions to the qualified company plans depend upon the design of the particular plan. Employees and employers who elect company plans receive a rebate on part of their payroll tax payments. Currently, employees receive a rebate equal to 1.6 percent of their earnings between the lower and upper limits. Employers receive a rebate of three percent on wages between the lower and upper limits.
A worker who is not enrolled in a company plan may elect to establish an "appropriate personal pension" plan and elect out of the government's SERPS benefit. The employee establishes such plans through a financial service provider. The employee must pay all regular payroll tax liabilities throughout the year, but at the end of the fiscal year the government pays over a rebate to the employee's appropriate personal pension.
Prior to the mid-1970s, the British social security system consisted solely of the basic state pension and was funded by annual lump sum contributions by both the employee and the employer. In addition, payments to beneficiaries also were funded by general revenues.
2. Australia(71)
The social security system in Australia is comprised of two tiers. The first tier is called the "age pension" benefit and the second tier is called the "superannuation guarantee."
The "age pension" benefit is unrelated to the beneficiary's earnings history. An individual qualifies based on age, residency, assets, and income. The full age pension benefit equals 25 percent of male average weekly earnings and was worth approximately $100 per week in 1997. The age pension benefit is reduced for asset holdings in excess of specified limits and for income earned beyond specified limits.
The "superannuation guarantee" mandates employer contributions to employer-provided pension funds. These pension funds generally are defined contribution plans, although some defined benefit plans remain in place.(72) Generally, the employer chooses a mutual fund to manage the investments. The current contribution rate equals seven percent of eligible wages. Under present law, the contribution rate will rise to nine percent of eligible wages in 2002. Employers do not have to make contributions for employees who earn less than $267 per month. Workers with earnings between $267 and $534 per month may elect to receive higher wages in lieu of superannuation contributions.(73) Further, contributions are not required for earnings in excess of approximately $56,000 per year. Contributions are immediately vested and portable. In addition to employer contributions, an employee may make a supplemental contribution to his or her superannuation fund and claim a 7.5 percent tax credit against his or her income tax liability. Self-employed persons are not covered under the superannuation guarantee mandate.
Prior to the creation of the current social security system, Australia provided only the means-tested "age pension" financed from general revenues.
3. Sweden(74)
In 1994, the Swedish parliament enacted changes to the Swedish social security system that would go into effect in 1999 with the first payouts under the new system to occur in 2001. The reformed system is comprised of two basic parts: an "income pension" and a "guarantee pension." The income pension will be funded by an 18.5-percent payroll tax on all wages, divided equally between the employee and the employer (9.25 percent on each). The guarantee pension is to be funded from general government revenues. The guarantee pension is a means-tested benefit, payable beginning at age 65. The benefit is equal to approximately 40 percent of the average wage of a blue collar employee.
The income pension is comprised of two parts. First, 16 percent of earnings are credited to an individual's account. However, this account is notional only. The "earnings" on this account are determined by real wage growth per capita in Sweden. There is no actual investment of notional accounts. The proceeds of this portion of the payroll tax are used to fund retirement benefits of current retirees. The individual may claim retirement benefits based upon his or her notional account balance at any time after age 61. The retirement benefit is calculated as an annuitized value of the account balance. However, the annuitized value is not a market-based annuity, but rather guarantees a real 1.6 percent annual return.
The remaining 2.5 percent of earnings collected by the payroll tax is contributed to an individual account that permits self-directed investments in registered investment funds. The individual can choose among domestic and foreign investment funds.(75) The investment funds do not manage numerous individual accounts. Rather, a government agency stands as intermediary between the individual and the investment funds, collecting the payroll taxes and investing lump sums in the various funds on behalf of numerous individuals.(76) The government agency provides the record keeping and reporting to the individual investors, as well as being the sole provider of annuities to individuals when they choose to take their retirement benefits. The individual may claim retirement benefits based upon his or her actual account balance at any time after age 61. The retirement benefit is determined by converting the account balance to a standard, market-based annuity.
Prior to the reforms, retirement pensions provided under the Swedish social security system consisted of two basic components: a national basic pension and a supplementary pension. All Swedish citizens and residents were entitled to the national basic pension, regardless of earnings. The payment received was determined relative to a "basic amount," set at $4,907 in 1995. A single person received 96 percent of the basic amount ($4,710 in 1995) and married persons each received 78.5 percent of the basic amount ($7,704 per married couple in 1995). The supplementary pension benefit depended upon the individual's earnings history. The maximum total pension benefit from both the national basic pension and the supplementary pension was $23,847 in 1995.
Employer contributions on all wages financed the Swedish social security system. In 1994, a payroll tax rate of 5.86 percent funded the national basic pension and a payroll tax rate of 13 percent funded the supplementary pension.(77) In addition to the payroll tax, general tax revenues supplemented the funding for the basic national pension. The payroll tax to fund the pre-2001 supplementary pension benefits has accumulated surpluses which have been invested predominantly in government bonds and housing bonds. However, since 1974, 15 percent of the accumulated surplus has been invested in domestic and foreign equities.
B. Newly Industrialized Countries
1. Chile(78)
The Chilean social security system mandates that employees contribute 10 percent of their qualified wages to a personal account managed by a qualified financial institution of their choosing. There is no employer contribution. An additional 3 percent of qualified wages is deducted to cover the administrative costs of the plan and to provide disability and survivor's insurance.(79) Qualified wages consists of all wages up to approximately $24,000 annually. In addition to the mandatory contributions, employees can make supplemental contributions to their accounts tax free, subject to an annual limitation. Self-employed workers are not required to participate, but they may voluntarily set up retirement accounts subject to the same regulations.
The financial institutions which maintain the individual accounts and the investment mix chosen by the managers are regulated by the government. Upon retirement, a beneficiary must purchase an indexed annuity or receive regulated periodic withdrawals. The Chilean system guarantees a minimum pension currently equal to approximately 75 percent of the prevailing minimum wage. For workers who have contributed to the system for at least 20 years and whose accumulated balances are insufficient to generate a pension equal to the minimum guaranteed pension, the government uses general revenues to fund the difference between the worker's accumulated balance and the amount necessary to fund the guaranteed minimum pension.
Prior to 1980, Chile financed social security on a pay-as-you-go basis. Employees and employers paid payroll taxes to a handful of institutions organized by occupational category. The payroll tax rates on employers generally were larger than those on employees. The system did not achieve universal coverage. Self-employed and informal sector workers, who comprise 25 percent or more of the Chilean labor force, were not covered by the system.(80)
2. Mexico(81)
The Mexican social security system mandates that all workers hold two old-age savings accounts, one with a private pension company or with a government administered fund and the second account with the publicly run housing fund (the Instituto del Fondo Nacional de la Vivienda de los Trabajaderos). Contributions equal to 6.5 percent of taxable wages are paid to individual old-age accounts and contributions equal to 5 percent of taxable wages are paid to the housing fund.(82) Payroll taxes on the employer and the employee and government contributions funded from general revenues finance these contributions. A payroll tax at a rate of 5.15 percent on employers and at a rate of 1.125 percent on employees is dedicated to the old age account. The government contributes an amount equal to 0.225 percent of an employee's taxable wages to the old age account. In addition, the government contributes an amount equal 5.5 percent of the prevailing minimum wage to each retirement account. Contributions to the housing fund are financed by a 5 percent payroll tax on employers. The taxable wage base includes all wages paid up to a value equal to 25 times the prevailing minimum wage.
Each private pension company currently offers one mutual fund. In the future, individuals will be able to choose among multiple mutual funds from the various private pension companies or from the government managed funds. Monies invested in the housing fund support mortgage loans to a low-income clientele. Contributions to both the old age fund and the housing fund are fully vested.
Upon retirement, a beneficiary must use accumulated balances in both accounts to purchase a private annuity or receive periodic withdrawals from their accounts under a regulated schedule. All beneficiaries meeting minimum contribution requirements are guaranteed a minimum pension equal to the Mexico City minimum wage. In the event a worker's accumulated savings are not sufficient to provide a pension equal to the guaranteed minimum pension, the government makes up the difference.
The Mexican social security system does not cover government workers or the self employed. In addition, those employees of Mexico's substantial informal sector, where payroll and other business records are not maintained, do not participate in the social security system.
Prior to 1992, Mexico maintained a pay-as-you-go social security system. Contributions equal to 8.5-percent of applicable wages financed old age and other social insurance benefits. An employee's wages up to a maximum amount equal to 10 times the prevailing minimum wage defined the applicable wage base. Payroll taxes comprised the bulk of the 8.5-percent. Employers paid 5.95 percent of taxable wages and employees paid 2.125 percent of taxable wages. In addition, the government, from other funds, contributed an amount equal to 0.425 percent of taxable wages to the social security fund. Covered employees also were required to contribute to the housing fund, thereby providing partial funding of future benefits.(83) Pension benefits were based on the beneficiaries earnings history. Under the old social security system, coverage was not universal. The system did not cover the self-employed, government workers, or employees of PEMEX (the government owned oil company). In addition, those who worked in Mexico's substantial informal sector generally did not appear on payroll records and were outside the system.
3. Argentina(84)
Argentinian social security benefits are determined under a two-tiered structure. The first tier of benefits is unrelated to earnings. The second tier of benefits is provided by either an earnings related defined benefit pension or by the individual's contributions to an individual account. The defined benefit option is a public plan funded on a pay-as-you-go basis. Once an individual elects the individual account option, he or she may not later transfer back to the defined benefit option.
Regardless of whether the employee elects the defined benefit option or the individual account option, the employee must contribute 11 percent of covered wages. Employers also contribute. Between 1993 and 1996, the employer contribution rate was 16 percent of covered wages. Since 1996, employers have contributed 12 percent of wages on average.(85) Self-employed persons contribute the combined employer and employee rates.(86) Covered wages are all wages up to an amount equal to 60 times the so-called average mandatory provisional contribution. The average mandatory provisional contribution is calculated twice per year by dividing the total contribution of employees by the total number of contributors. In 1997, the ceiling on covered wages was $57,600.
The first tier benefit is available to all workers with 30 years of contributions upon reaching age 64 for men or age 59 for women.(87) This basic pension benefit is related to the average mandatory contribution and was $2,400 per year in 1997. The benefit amount increases by one percent for each year beyond 30 for which the beneficiary contributed to the system.
Employees who elect the defined benefit pension for the second tier of their benefit receive 0.85 percent of their average covered wages earned during their final 10 years of employment multiplied by the number of years during which they contributed to the system. However, benefits are limited by a maximum benefit. The maximum defined benefit pension amount in 1997 was $960 per year.
Employees who elect the individual account option for their second tier benefit designate their 11 percent payroll tax to a retirement account managed by a public agency or by private firms. Upon retirement, the employee uses the accumulated balances to purchase an annuity from a private insurance company or received specified periodic payments. Certain early withdrawals are permitted if the accumulated balances are sufficient to provide specified pension benefits.
Prior to 1994, Argentina maintained a pay-as-you-go social security system. Payroll taxes and other earmarked taxes funded the benefits. The pension system had two parts. One part covered employees. The second part covered the self employed. A unified payroll tax schedule funded both parts, but benefit rules differed. In 1993, the payroll tax rate was 26 percent. Other revenue also supplemented the payment of benefits when necessary.(88)
1. This document may be cited as follows: Joint Committee on Taxation, Analysis of Issues Relating To Social Security Individual Private Accounts (JCX-14-99), March 15, 1999.
2. For more discussion, see the W&M Committee Print 105-7, the "1998 Greenbook," May 19, 1998, which was compiled by the staff of the Committee on Ways and Means, U.S. House of Representatives.
3. There are certain statutory exceptions from Social Security coverage. The majority of the 6.5 million non-covered workers in 1996 worked for the Federal Government or State or local governments. All Federal employees hired after 1983 are covered under the OASDI program. Prior to July 1, 1991, States and local governments could enter into voluntary agreements with the Secretary of Health and Human Services which allowed the State or local government or its employees to decide whether to participate in Social Security, participate in a public retirement plan, or not to participate in any retirement system. After June 30, 1991, services performed by each employee of a State or local government who is not personally participating in a public retirement plan are mandatorily covered by Social Security.
4. There is no limit on taxable wages for the hospital insurance ("HI") payroll tax which is imposed in addition to the OASDI payroll tax.
5. This does not include the payroll tax for HI, which is imposed at a current rate of 1.45 percent each on the employee and the employer.
6. This includes 6.2 percent for the OASDI and 1.45 percent for the HI payroll taxes.
7. Similar treatment is given to tax liabilities under the hospital insurance HI portion of the payroll tax.
8. Employers are not required to maintain a qualified plan; thus, it is up to the employer to determine whether to establish a plan and what kind of plan to establish.
9. Qualified plans are subject to regulation under both the Internal Revenue Code and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). Some rules are in both the Code and ERISA. Some, such as limits on contributions and nondiscrimination rules, are only in the Code, and some, such as fiduciary, reporting, and disclosure rules, are only in ERISA.
10. Matching contributions and employee after-tax contributions are also subject to a special nondiscrimination test.
11. Under the first schedule, called 5-year cliff vesting, a participant has no vested right to his or her accrued benefit until he or she has 5 years of service. After 5 years of service, the participant is 100 percent vested. Under the second schedule, benefits vest over a period of 7 years.
12. Earnings on amounts attributable to employee elective deferrals cannot be distributed on account of hardship. Employer matching contributions and nonelective contributions made to a section 401(k) plan are not subject to these distribution restrictions unless they are used to satisfy the special nondiscrimination test applicable to section 401(k) plans. Such contributions may generally be distributed after two years, if the plan so permits.
13. A more complete description of the TSP can be found in The Summary of the Thrift Savings Plan for Federal Employees, prepared by the Federal Retirement Thrift Investment Board; and The Financial Statements of the Thrift Savings Fund - 1997 and 1996, prepared by Arthur Andersen LLP.
14. Beginning in the year 2000, two new funds will be added, a small cap index fund, (the "S fund") and an international index fund, (the "I fund").
15. For a married participant, spouse's rights requirements will apply to the withdrawal choice.
16. In some cases, an IRA can be used by an employer as an employer-sponsored retirement plan.
17. The AGI phase-out range for married taxpayers filing a joint return is scheduled to increase so the range will be as follows: for 2000, $52,000 to $62,000; for 2001, $53,000 to $63,000; for 2002, $54,000 to $64,000; for 2003, $60,000 to $70,000; for 2004, $65,000 to $75,000; for 2005, $70,000 to $80,000; for 2006, $75,000 to $85,000; and for 2007 and thereafter, $80,000 to $100,000. The AGI phase-out range for single taxpayers is scheduled to increase as follows: for 2000, $32,000 to $42,000; for 2001, $33,000 to $43,000; for 2002, $34,000 to $44,000; for 2003, $40,000 to $50,000; for 2004, $45,000 to $50,000; and for 2005 and thereafter, $50,000 to $60,000.
18. An IRA can also be an individual retirement annuity, as well as an individual retirement account. Individual retirement annuities provide an annuity.
19. National Academy of Social Insurance, "Report of the Panel on Privatization of Social Security" (November 1998).
20. Another issue that may arise under proposals that base contributions on wages and self-employment earnings is how to deal with individuals who have more than one employer or have both wage income and self-employment income. This issue arises under present law because there is a cap on Social Security earnings.
21. Under present law, payroll taxes and receipts are not reconciled on an individual basis.
22. Note that depending on the IPA system adopted, transferring actual funds to the IPA may not be required. Rather, the IPA could be a bookkeeping account to which contributions (and appropriate earnings) are credited.
23. An appropriate starting point for crediting of investment earnings would need be to be determined. For example, one approach would be to credit earnings as if contributions had been made on a monthly basis based on monthly wages. Such an approach might require more information regarding wages and self-employment earnings than is currently provided to SSA.
24. Employers currently provide quarterly information regarding employment taxes on Form 941. However, this information is provided on an aggregate basis, not an individual basis.
25. This issue is discussed further in Part IV.B.3., below.
26. As mentioned previously, this discussion assumes mandatory contributions to private accounts. To the extent contributing is voluntary, permitting preretirement access could also induce some individuals to contribute to the account (or to contribute more to the account). Some individuals who may be concerned that they will need funds before retirement may be reluctant to place funds in an account that cannot be accessed in case of emergencies.
27. This issue is a subset of the issue relating to how a guaranteed benefit may affect investment decisions, which is discussed in Part IV.B.4., below.
28. Policy implications of the tax treatment of distributions is discussed below in Part IV.B.
29. It should be noted that couples living in States governed by community property laws may be subject to different rules.
30. See, for example, Martin Feldstein, "Savings Grace," The New Republic, April 6, 1998.
31. Available evidence shows that the investment mix in private defined contribution plans in which individuals direct their own investments is 40 percent equities, 15 percent bonds, and 45 percent cash and other assets, including real estate (see Employee Benefits Research Institute Databook, 4th edition, 1997, p. 102).
32. Such costs could also include sales costs and a return on capital for any private insurer offering the annuities. Such costs could result in substantial reductions in the reported annual annuity payments. For a discussion of these issues, see James Porterba and Mark Warshawsky, "The Costs of Annuitizing Retirement Payouts from Individual Accounts," National Bureau of Economic Research, Working Paper 6918, January 1999.
33. Life expectancy estimate based on life expectancy tables of IRS Publication 590.
34. See the discussion in Part II. B and D., above.
35. While this constraint may be relaxed somewhat by inflows of foreign capital, it would usually require an increase in interest rates to attract this capital. Such rising interest rates (borrowing costs) would mean that some investments that would otherwise be made will not be made. Additionally, to the extent investments are financed from foreign capital, the returns to capital from such investments will flow abroad.
36. This issue is similar to the debate as to whether the tax incentives for IRA contributions have contributed to increased personal saving, or whether individuals have largely shifted other forms of saving into IRAs. See Joint Committee on Taxation Description And Analysis Of Tax Proposals Relating To Individual Saving And IRAs (JCS-2-97), March 3, 1997, for a discussion of these issues.
37. It is possible that some individuals would choose to offset non-IPA saving by more than a dollar for each dollar of IPA contributions. For this to be rational, the individual would have to be a "target" saver--that is, a saver who seeks to accumulate a given dollar amount of saving at some future point for a specific purpose (such as buying a car, or retirement)--and the IPA would have to be more tax favored than at least some of the other forms of saving that the target saver undertakes. If the IPA is more tax favored than some non-IPA accounts, a target saver would offset less tax-favored saving by more than a dollar for each dollar in the IPA, as fewer IPA dollars would be necessary to achieve the future target as a result of the advantages of tax deferral. For further discussion of target saving, see Andrew Samwick, "Tax Reform and Target Saving," National Tax Journal, Volume LI, No. 3, September 1998.
38. A tax system is considered to be progressive if average tax rates rise with income. Similarly, a benefit system is progressive if benefits increase as a share of income as income falls.
39. To see this, consider an economy represented by one person with $100 in wage income in his or her working life, on which $20 is paid in taxes to finance the only government service--a future retirement benefit. The taxpayer thus has $80 in after-tax income at his or her disposal to either consume during his or her working life or to save a portion to supplement retirement income. If a new tax of $2 is imposed and deposited to an IPA in the taxpayer's name to pay retirement benefits, the taxpayer would now have only $78 in after-tax income at his or her disposal to consume during his or her working life. Alternatively, a mandate that the taxpayer fund such an IPA from his or her $80 in after-tax disposable income would leave $78 in disposable income during the taxpayer's working life, and $2 in the taxpayer's IPA. Hence, the two approaches are equivalent.
40. To the extent that all workers have account contributions, the contributions cannot represent transfers for all taxpayers, as at least some must bear the burden of the taxes.
41. The contribution to a Roth IRA is chosen to simplify the example--the decision to save in any form could supplement retirement income.
42. This can be thought of equally as either a requirement that he contribute $2, or that his taxes are raised by $2 and the $2 is returned to him to fund the IPA.
43. The Vanguard Group, the operator of the largest S&P 500 stock index fund, reports a portfolio expense ratio (the ration of expenses to assets under management) of .19 percent for the year ended December 31, 1997. By contrast, according to Lipper, Inc., which tracks the performance of the mutual fund industry, the average growth equity fund had an expense ratio of 1.53 percent for the year ended December 31, 1997.
44. In general, from society's perspective as a whole, it is best that the investments with the highest expected return be undertaken. If people are on average risk averse, however, certain high expected value, but high risk investments, will not be undertaken in favor of safer, lower return investments. Thus, it could be argued that the government should subsidize the risk taking. However, if the government takes too great a share of the downside risk, or too little a share of the upside gain through taxes (relative to the share of downside risk), it could encourage risk taking that is not expected to produce, for society as a whole, a greater return than less risky investment. Such an incentive would be detrimental to long term growth.
45. In general, risk is defined as the variance in an asset's return about it's expected return. Thus, for two assets that are expected to produce a 10 percent return on average, the asset whose return generally falls between eight percent and 12 percent would be less risky than the asset whose return could be as low as zero or as high as twenty percent, though both are expected to return 10 percent on average.
46. Calculations by staff of the Joint Committee on Taxation based on Social Security Administration, Annual Statistical Supplement to the Social Security Bulletin, 1998, November 1998, Table 3.E.3.
47. Statistical Abstract of The United States 1997, Table 1200, p. 725.
48. Statistical Abstract of The United States 1997, Table 780, p. 513.
49. Social Security benefit recipients with modified adjusted gross income exceeding certain limits are required to include up to 85 percent of their benefits in income. The Joint Committee on Taxation staff projects that, in 1999, 33 percent of all elderly will include some portion of Social Security benefits in taxable income.
50. Earnings are indexed by the rate of wage growth. Highest career earnings are defined as the average of the highest five years of earnings.
51. This measure is calculated only for those individuals who worked a significant amount during the five years preceding retirement.
52. Susan Grad, "Earnings Replacement Rates of New Retired Workers," Social Security Bulletin, 53, October 1990.
53. Alan L. Gustman and Thomas L. Steinmeiner, "Effects of Pensions on Savings: Analysis with Data from the Health and Retirement Study." National Bureau of Economic Research, Working Paper #6681, August 1998. Replacement rates in this study are measured relative to pre-retirement earnings of the household.
54. The reported replacement rates measured replacement income in terms of nominal dollars. If the calculation were to account for future inflation, the authors estimated that real (inflation adjusted) replacement rates averaged 60 percent across all of the households in the sample and 66 percent of the real value of the pre-retirement earnings for the median 10 percent of households. See, Gustman and Steinmeier, "Effects of Pensions on Savings," pp. 18-19.
55. James F. Moore and Olivia S. Mitchell, "Projected Retirement Wealth and Savings Adequacy in the Health and Retirement Study," National Bureau of Economic Research, Working Paper # 6240, October 1997. Moore and Mitchell estimate that the necessary saving rate falls to 7 percent per year if the household would defer retirement until age 65. Moore and Mitchell measure "pre-retirement consumption" by reference to replacement rates of less than 100 percent. Thus, if a 100-percent replacement rate were the goal, an even greater saving rate would be necessary.
56. Social Security Administration, Annual Statistical Supplement to the Social Security Bulletin, 1998, November 1998, Table 3.E.2.
57. For a discussion of the legislative history of Social Security coverage, see Committee on Ways and Means, 1998 Green Book (WMCP 105-7), May 19, 1998, pp. 6-11.
58. EBRI Databook on Employee Benefits, Fourth Edition 1997. Table 10.2 on page 84 reports that in 1975, 31 million employees were participants in private sector pension plans. By 1993 this number had expanded to 45 million employees. Among all civilian workers, the percentage participating in a pension plan has grown from 44 percent in 1979 to 51 percent in 1993 (Table 10.4, p. 86).
59. Some private-sector employees contribute to 403(b) tax-sheltered annuities instead of 401(k) plans.
60. Gustman and Steinmeier, "Effects of Pensions on Savings," pp. 8-9.
61. J.R. Woods, "Pension Coverage Among Private Wage and Salary Workers: Preliminary Findings from the 1988 Survey of Employee Benefits," Social Security Bulletin, 52, p.17.
62. J.A. Turner and D. Beller, Trends in Pensions (Washington, D.C.: U.S. Department of Labor), 1989, pp. 65 and 357.
63. National saving is generally divided into private saving and public saving. Private saving is comprised of household or personal saving and business saving. (See Table 10) Households save by not spending all of their disposable income (i.e., after-tax income). In Tables 10 and 11, personal saving is measured as the difference between household income and household consumption. In addition, the National Income and Product Accounts attribute all corporate pension contributions and earnings on accumulated pension balances as saving by the household sector and, hence, part of personal saving. Personal saving does not include changes in values of household assets, such as have occurred over the past few years as stock market values have increased. Businesses save by retaining some of their earnings. Table 10 presents net saving, which equals gross saving less capital consumption (depreciation). Public saving reflects the extent to which the Federal, State, and local governments run budget surpluses or deficits. The National Income and Product Accounts also adjust government surpluses for depreciation of government assets. Hence, public saving, like business saving, is measured as net saving. Table 10 presents data on the components of net national saving in the United States.
64. "Gross financial assets" reports only the "asset side" of the family's balance sheet. That is, these figures do not net out the value of any of the family's financial liabilities such as mortgage or consumer debt. "Gross financial assets less retirement assets" subtracts IRA and defined contribution plan asset balances from reported gross financial assets. Neither figure includes a calculation of the value of any accrued defined benefit pension plan benefits.
65. Congressional Budget Office, "Baby Boomers in Retirement: An Early Perspective," September 1993, p. xiv. Also see, Joyce Manchester, "Baby Boomers in Retirement: An Early Perspective," in Dallas Salisbury and Nora Super Jones (eds.), Retirement in the 21st Century: Ready or Not? (Washington: Employee Benefits Research Institute), 1994.
66. B. Douglas Bernheim, "Adequacy of Savings for Retirement and the Role of Economic Literacy," in Dallas Salibury and Nora Super Jones (eds.), Retirement in the 21st Century: Ready or Not? (Washington: Employee Benefits Research Institute), 1994. Also see Laurence Kotlikoff and Alan J. Auerbach, "U.S. Fiscal and Savings Crises and Their Impact for Baby Boomers" in the same volume. Bernheim and Kotlikoff and Auerbach project potential consumption paths of baby boomers based on their current accumulation of assets and consumption behavior. Both studies conclude that baby boomer saving is, on average, inadequate for that generation to maintain its standard of living in retirement. Bernheim estimates that, holding constant their participation in qualified plans, baby boomer non-retirement plan saving is at one-third the rate necessary to maintain pre-retirement consumption.
67. For a brief review of this literature, see Daniel B. Radner, "The Retirement Prospects of the Baby Boom Generation," Social Security Bulletin, 61, 1998, pp. 3-19.
68. Congressional Budget Office, Social Security Privatization: Experiences Abroad, January 1999. Also see Richard Disney, "The United Kingdom's Pension Program," in Steven A. Sass and Robert K. Triest, eds., Social Security Reform Conference Proceedings: Links to Saving, Investment and Growth, (Boston: Federal Reserve Bank of Boston), 1997, pp. 157-167, Richard Blundell and Paul Johnson, "Pensions and Retirement in the UK," National Bureau of Economic Research Working Paper #6154, September 1997, and Alan Budd and Nigel Campbell, "The Roles of the Public and Private Sectors in the U.K. Pension System," in Martin Feldstein, (ed.), Privatizing Social Security, (Chicago: University of Chicago Press), 1998.
69. All figures in this section are expressed in U.S. dollars for comparison purposes.
70. There is a separate formula for self-employed persons who choose the government's SERPS benefit.
71. CBO, Social Security Privatization. Also see Malcolm L. Edey, "Retirement Income Policy in Australia," in Steven A. Sass and Robert K. Triest, (eds.), Social Security Reform Conference Proceedings: Links to Saving, Investment and Growth, (Boston: Federal Reserve Bank of Boston), 1997, pp. 168-173, Malcolm Edey and John Simon, "Australia's Retirement Income System: Implications for Saving and Capital Markets," National Bureau of Economic Research Working Paper #5799, October 1996, and Malcolm Edey and John Simon, "Australia's Retirement Income System," in Martin Feldstein, (ed.), Privatizing Social Security, (Chicago: University of Chicago Press), 1998.
72. Prior to a series of policy changes beginning in 1986 mandating coverage and the current system, many employers and governments offered employees pension benefits through defined benefit plans. Many of these older plans remain in place. Newly adopted plans generally have been defined contribution plans. See, Edey, "Retirement Income Policy in Australia," p. 169.
73. Commonwealth Treasury of Australia, 1997-98 Budget Paper No.2: Budget Measures 1997-98 (Canberra: Australian Government Publishing Service, 1997), pp. 191-192.
74. See Mårten Palme and Ingemar Svensson, " Social Security, Occupational Pensions, and Retirement in Sweden," National Bureau of Economic Research Working Paper #6137, August 1997, and Annika Sundén, "The Swedish Pension Reform," xerox, Federal Reserve Board of Governors, September 1998.
75. In addition, the government will manage an investment fund for those individuals who do not wish their funds to be managed by private investment funds.
76. The government agency will hold individual contributions for up to 18 months while individual earnings records are reconciled. During this period the agency will invest the funds in short term investments such as government notes and credit individual accounts with interest income.
77. In addition employers pay a payroll tax rate of 0.2 percent to finance pension benefits of part-time workers.
78. CBO, Social Security Privatization. Also see Julia Lynn Coronado, "The Effects of Social Security Privatization on Household Saving: Evidence from the Chilean Experience," Federal Reserve Board of Governors, Finance and Economics Discussion Series Working Paper, 1998-12, Olivia S. Mitchell and Flávio Ataliba Barreto, "After Chile, What? Second-Round Pension Reforms in Latin America," National Bureau of Economic Research Working Paper #6316, December 1997, and Sebastian Edwards, "The Chilean Pension Reform: A Pioneering Program," in Martin Feldstein, (ed.), Privatizing Social Security, (Chicago: University of Chicago Press), 1998.
79. Employers pay for worker compensation insurance.
80. Coronado, "The Effects of Social Security Privatization on Household Saving," p. 5.
81. CBO, Social Security Privatization. Also see Carolos Sales-Sarrapy, Fernando Solis-Soberón, and Alejandro Villagómez-Amezcua, "Pension System Reform: The Mexican Case," in Martin Feldstein, (ed.), Privatizing Social Security, (Chicago: University of Chicago Press), 1998, Agustin G. Carstens, "The Reform of Social Security in Mexico," in Steven A. Sass and Robert K. Triest, eds., Social Security Reform Conference Proceedings: Links to Saving, Investment and Growth, (Boston: Federal Reserve Bank of Boston), 1997, pp. 153-156, and Mitchell and Barreto, "After Chile, What? Second-Round Pension Reforms in Latin America."
82. In addition, contributions equal to 4 percent of taxable wages finance disability and life insurance and retiree medical insurance.
83. Over the past several years, the housing funds has yielded negative returns on its lending activities.
84. CBO, Social Security Privatization. See. Mitchell and Barreto, "After Chile, What? Second-Round Pension Reforms in Latin America," and Joaquín Cottani and Gustavo Demarco, "The Shift to a Funded Social Security System: The Case of Argentina," in Martin Feldstein, (ed.), Privatizing Social Security, (Chicago: University of Chicago Press), 1998.
85. The employer contribution rate varies by geographic region.
86. Contributions of self-employed persons are based on the 27-percent rate applied to a schedule of "reference" or estimated incomes.
87. The retirement age is scheduled to rise to 65 for men and 60 for women beginning in 2001.
88. In 1993, in addition to payroll tax collections, the social security system received 10 percent of VAT receipts, 20 percent of income tax receipts, 100 percent of personal wealth tax receipts, and 30 percent of revenues from the sale to the public of state enterprises. Cottani and Demarco, "The Shift to a Funded Social Security System."
