August 21, 2001

Voluntary Individual Accounts for Social Security:
What Are the Costs?

by Peter R. Orszag and Robert Greenstein (1)

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Proposals for Social Security reform sometimes include voluntary individual accounts, under which individuals can choose to participate fully in the existing Social Security system or to divert some of their payroll contributions into their own individual accounts. President Bush has endorsed such voluntary individual accounts. One of the Bush Administration's guiding principles for Social Security reform — and for the Social Security commission it has appointed — is that "Modernization must include individually controlled, voluntary personal retirement accounts, which will augment Social Security."

The Bush Administration sometimes argues that voluntary accounts must be beneficial, since no one is forced to contribute to them. That argument may be politically beneficial to the Administration, since it may make the individual account proposal appear eminently reasonable. But the reality is more complicated. Voluntary individual accounts involve difficult tradeoffs, and experience with such accounts in other countries has proven troubling.

Voluntary individual accounts involve difficult tradeoffs, and experience with such accounts in other countries has proven troubling.

Voluntary individual accounts could be financed either from existing Social Security revenue (such accounts are known as "carve out" accounts) or from non-Social Security revenue (in which case, the accounts are sometimes referred to as "add on" accounts). As other Center analyses have explained, the combination of the large tax cut recently signed into law and the other initiatives reflected in the Congressional budget resolution (such as a prescription drug benefit) consume virtually all of the surpluses outside Social Security and Medicare Hospital Insurance after 2002, precluding the possibility of financing add-on accounts out of that surplus.(2) This analysis therefore focuses on carve-out voluntary accounts, in which an individual may elect to establish an account financed by diverting a portion of the individual's payroll tax contributions to an individual account. Such an approach was embodied in legislation introduced in 1998 by then-Senator Daniel Patrick Moynihan, who is now one of the co-chairs of the commission appointed by President Bush to recommend changes in Social Security.

This analysis examines several difficult issues raised by carve-out voluntary individual accounts.

"We typically think that giving people choice is optimal since people can decide what is best for them. Thus, the economic bias is to believe that, if people want to opt out of social security, they should be allowed to do so. In the context of social security privatization, however, this analysis is not right. Allowing people to opt out of social security to avoid adverse redistribution is not efficient; it just destroys what society was trying to accomplish....An analogy may be helpful. Suppose that contributions to national defense are made voluntary. Probably, few people would choose to contribute; why pay when you can get the public good for free? Realizing this, we make payments for national defense mandatory. The same is true of redistribution. Redistribution is a public good just as much as national defense; no one wants to do it, but everyone benefits from it. As a result, making contributions to redistribution voluntary will be just as bad as making contributions to national defense voluntary. We need to make redistribution mandatory, or no one will pay for it."(3)

Making the individual accounts voluntary would significantly increase the administrative costs of running an individual account system. The higher the administrative costs, the smaller the amount of assets that builds in an account, since the administrative costs eat up some of the assets.

These factors suggest that voluntary carve-out individual accounts pose unique challenges, which is why most proponents of individual accounts would make such accounts mandatory. Voluntary accounts also share many of the drawbacks associated with any system of carve-out individual accounts, including mandatory systems. For example:

Other Center analyses have examined various issues related to individual accounts.(5)



The experience in the United Kingdom should serve as a warning. Vulnerable members of society were given misleading advice regarding the benefits of individual accounts, while high administrative costs have sharply reduced the retirement benefits that those with such accounts will receive. The fact that accounts are voluntary does not mean they may not be harmful.

Voluntary individual accounts could attenuate the social compact behind Social Security by allowing higher-income workers to opt out of part of the system, thereby leaving the rest of the Social Security program with fewer resources to redistribute toward lower earners and a relatively larger burden to bear in honoring the Social Security commitments made to retirees and older workers. Voluntary accounts also would involve a variety of difficult administrative issues.

Experience from other countries that have experimented with voluntary accounts is not encouraging. The experience in the United Kingdom should serve as a forceful indicator of the potential problems associated with voluntary individual accounts. The United Kingdom has witnessed a scandal in which vulnerable members of society were given misleading advice regarding the benefits of individual accounts. The United Kingdom also has suffered from high administrative costs under its voluntary individual account system. These costs sharply reduce the retirement benefits that those with such accounts will eventually receive.

It also is important to remember that voluntary individual accounts do nothing in and of themselves to improve Social Security's financial condition. To the extent that they divert current revenue away from Social Security, they could exacerbate the Social Security shortfall.

Policy-makers considering a system of voluntary individual accounts in the United States should carefully examine the potential costs involved. The fact that the accounts are voluntary does not mean they are not potentially harmful.

End Notes:

1. Peter Orszag is a senior fellow in economic studies at the Brookings Institution. Robert Greenstein is the executive director of the Center on Budget and Policy Priorities.

2. Richard Kogan, Robert Greenstein, and Joel Friedman, "How Much of the Surplus Remains After the Tax Cut?," Center on Budget and Policy Priorities, June 2001, and Peter Orszag and Robert Greenstein, "Financing Individual Accounts in the Aftermath of the Tax Bill: The Challenge Facing the Bush Social Security Commission," Center on Budget and Policy Priorities, June 2001. See also Peter R. Orszag, "The Implications of the Tax Bill for Social Security Reform: The Challenges Facing the Bush Social Security Commission," Testimony before the Senate Budget Committee, August 2, 2001.

3. David Cutler, "Comment on Gustman and Steinmeier, 'Privatizing Social Security: Effects of a Voluntary System'", in Martin Feldstein, editor, Privatizing Social Security (University of Chicago Press: Chicago, 1998), page 358.

4. Benefits represent a somewhat smaller percentage of total Social Security revenue, including interest on the bonds held by the Trust Fund.

5. See, for example, the following Center reports: "All That Glitters Is Not Gold: The Feldstein-Liebman Analysis of Reforming Social Security with Individual Accounts," April 26, 2000; "Archer-Shaw Social Security Proposal," April 28, 1999; "Administrative Costs in Individual Accounts in the United Kingdom," March 16, 1999; "Individual Accounts and Social Security: Does Social Security Really Provide a Lower Rate of Return?" March 9, 1999; "The Feldstein Social Security Plan," December 16, 1998; "Social Security Plans That Reduce Social Security Retirement Benefits Substantially Are Likely to Cut Disability and Survivors Benefits as Well," December 15, 1998; "African Americans, Hispanic Americans, and Social Security: The Shortcomings of the Heritage Foundation Reports," Rev., October 1998, and "How Would Various Social Security Reform Plans Affect Social Security Benefits? An Analysis of the Congressional Research Service Report," September 1998.