Justifying and Administering Personal Accounts

A comment on my last post suggests that, with personal accounts, the devil is in the details. That is true, and the broader point is also true: people who advocate for personal accounts should specify exactly how they would work.

Let me begin by explaining why I think personal accounts are necessary if Social Security's future deficits are to be prefunded. Here are some background numbers. The 2004 Trustees Report projects that the annual deficit will be 6 percentage points of taxable payroll in 2080, that taxable payroll will be about 34.2% of GDP that year, and that GDP in 2004 is about $11.544 trillion. When the Social Security actuaries evaluated the President's Commission's reforms that included equity investments, they use an expected return of 6.5% for the equity component and 4.6% for the whole portfolio, net of investment costs of 30 basis points.

Okay, so if we want to close a gap equal to 6 percentage points of taxable payroll with investments earning 4.6 percent, then we need a portfolio that is equal to 6/4.6 = 130% of taxable payroll at that point to support the beneficiaries. If we had such a portfolio today, it would be 1.30*0.342*11.544 = $5.1 trillion. I think that a portfolio of that size is too big to be managed centrally by the federal government and thus requires decentralized, private management. To put it in perspective, the Investment Company Institute reports that the total of all mutual funds was $7.6 trillion in September 2004.

What about the details? The commenter asked for a reference. The best book that I have seen on the issue of how to administer the accounts is this one: Administrative Aspects of Investment-Based Social Security Reform. Based on what's in that volume, as well as discussions with others and my own research, here's how I would answer the commenter's questions:

How do you propose that the accounts will be managed?

We establish a clearinghouse at the Social Security Administration that keeps track of one extra piece of information--the individual worker's choice of fund management company. As payroll taxes are collected, the relevant portion of each worker's payment that goes to the personal accounts is allocated to the fund company. This takes care of most of the record keeping linking the Social Security system to the accounts. Seems like this is just a spreadsheet with millions of rows and just a few columns.

Under what costs controls, be they fees to private companies or something else?

To be eligible to be a fund management company for this system, each financial institution would have to provide at least one low-cost, diversified option similar to the Thrift Savings Plan for federal employees. This would be the default option at each institution. Investors could voluntarily choose to move their money into more actively managed funds, which charge higher fees, but the low-cost option has to be available. They can change fund management companies by changing their election on their employment forms.

How will investment decisions be allowed? What investment opportunities will be offered to me?

Similar to 401(k) plans that do not invest in company stock, not IRAs or brokerage accounts. All investments must be in diversified mutual funds.

What will be rules be for taking money out of the accounts once I'm at retirement age?

My preference is mandatory annuitization, but I think this depends on how solvency was restored to the traditional system. If that occurred by raising the normal and early retirement ages, then the rules here can be more flexible, because the late-in-life payments going to the oldest beneficiaries will have the same generosity as under current law. If solvency was restored by a reduction in per capita benefits (like what is suggested in Commission Model 2), then we need stricter rules about annuitization.

I couldn't begin to list all the issues here.

I agree. The one thing that you didn't mention that is always a sticking point is the presence of small accounts, by low-income earners and teenagers and others who currently pay a small amount of payroll taxes to the current system. The clearinghouse mentioned above should simply hold these contributions and accumulate them at the Treasury rate until the account is sufficiently large (maybe $5,000) as to be of interest to financial institutions.