Social Security: “Transition Costs”

Social Security: “Transition Costs”

Order Code RS22010
Updated July 25, 2007
Social Security: “Transition Costs”
Laura Haltzel
Specialist in Social Security
Domestic Social Policy Division
Summary
The chief actuary of the Social Security Administration (SSA) forecasts that under
current law, the Social Security Trust Funds will be depleted in 2042.1 Many Members
of Congress have expressed concern that restoring the program to long-term fiscal
balance will impose burdens on future generations by requiring them to pay higher taxes,
accept benefit cuts, or undertake substantial government borrowing to pay the full
benefits promised under current law.
Some policy analysts have suggested that pre-funding Social Security benefits
through individual accounts (IAs) could improve the solvency of the current system,
thus reducing or eliminating the need for higher taxes, lower benefits, or increased
borrowing. However, there is general agreement among economists that any transition
to a pre-funded system results in additional costs, so-called “transition costs,” in the
short-run. Most Social Security tax revenues are immediately used to fund payments
to current Social Security beneficiaries. Therefore, a system of individual accounts that
is funded by diverting part of the current Social Security tax into individual accounts
will worsen the fiscal imbalance of Social Security and the overall budget, at least
temporarily. Over a 75-year period, individual accounts could improve the unfunded
liability of the Social Security system by $0.8 trillion or worsen it by up to $4.6 trillion,
depending on how the account is structured. However, beyond the 75-year actuarial
period, the benefit offset feature of most individual accounts would ultimately cover
these transition costs and improve the long-term solvency of the Social Security system,
leading some to refer to “transition costs” as “transition investments.” This report will
be updated as legislative developments occur.
1 The analysis in this report presents the effect on solvency of the IA component of reform
proposals int the 108th Congress (see Table 1). Since the SSA’s Office of the Chief Actuary has
not published actuarial memoranda on any of the Social Security reform proposals introduced in
the 110th Congress, we are unable to update Table 1 of this report accordingly. As the analysis
in Table 1 is based on the 2003 and 2004 Trustees Report assumptions, we use these assumptions
throughout the report.

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Since its inception in 1935, financing for the Old-Age, Survivors and Disability
Insurance (OASDI) program, more commonly known as Social Security, has been based
primarily on the concept of “pay-as-you-go” or PAYGO.2 Under the PAYGO system the
Social Security contributions of today’s workers fund the Social Security retirement,
survivor or disabled worker benefits of today’s beneficiaries. Congress selected this
method of financing because of the great number of older Americans who were living in
poverty at the time of the Great Depression. Congress decided that this generation of
older persons should receive Social Security benefits, despite not having contributed to
the system, because of the severity of the economic situation at the time and because most
of them would not have been able to find employment and then contribute to the system
long enough to be eligible for benefits.
As a result of the PAYGO system, most of Social Security’s annual revenues are
immediately paid out as benefits to current retirees, survivors or disabled workers. Social
Security’s annual revenues come from three main sources: the payroll tax on earnings (the
FICA (Federal Insurance Contributions Act) tax and the SECA (Self-Employment
Contributions Act) tax); interest earned on the Treasury bonds held by the Trust Funds;
and, revenues from the taxation of Social Security benefits. In 2003, Social Security
revenues equaled $632 billion and Social Security outlays totaled $479 billion, or 75%
of revenues. Thus, in 2003, Social Security had a surplus of $153 billion, or 25% of
revenues. These Social Security surplus dollars are not held by the Social Security Trust
Funds. Rather, according to law, surplus receipts are credited to the Social Security Trust
Funds in the form of special-issue non-marketable Treasury bonds. The actual surplus
dollars are held by the U.S. Treasury where they become part of the general revenue pool
and can be used to increase spending, reduce taxes, or reduce the government debt.
Unless these dollars are used to reduce government debt, they are not really being ‘saved’
to pay for future Social Security benefits. In recent years, the Social Security surpluses
have been used to offset increased spending or reduced taxes since the rest of the
government’s budget has been in deficit. Many economists have suggested that switching
from a PAYGO system to a fully ‘pre-funded’ system would increase the government’s
ability to pay future benefits because payroll taxes contributed to Social Security would
increase savings instead of being spent by the government.
What Are “Transition Costs”?
Shifting from a PAYGO system to a pre-funded system creates transition costs.
Under a pre-funded system, the dollars that are contributed by today’s workers are used
to pay benefits for today’s workers when they retire. Currently, today’s workers’
contributions are being used to pay benefits to yesterday’s workers. Thus, in order to
transition from a PAYGO to a pre-funded system, additional dollars must be found to
continue payment of benefits to yesterday’s workers. Most of the proposals that were
introduced in the 108th Congress would use a system of individual accounts to accomplish
2 Social Security is no longer a purely PAYGO system. Under a purely PAYGO system, the
annual taxes taken in from current workers and employers approximately equal the annual
benefits paid out. However, in the 1983 Social Security Amendments, the Social Security payroll
tax was increased in order to build a Social Security surplus, which was intended to improve the
ability of the program to pay benefits in the future, particularly to the “baby boom” generation.
This partial build up of reserves is referred to as “partially advance funding.”

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this pre-funding.3 Any use of individual accounts to pre-fund Social Security benefits will
necessarily impose additional costs, at least temporarily, because the nation will be paying
for the Social Security benefits of current retirees and making contributions to current
workers’ individual accounts.4
Many Social Security reform proposals that include some type of individual account
(IA) would re-direct part of the current-law payroll tax into the individual accounts and
are thus known as “carve-out” accounts. This diversion of revenues from Social Security
would reduce the revenue available to pay annual benefits and would create an additional
funding gap between current-law revenues and current-law obligations. This additional
cost is called a “transition cost” because it arises as a result of a transition to a system of
individual accounts. To the extent that the moneys diverted to the IAs are smaller than
the annual Social Security surplus in any given year, the carve-out will not affect the
annual payment of benefits, but it would affect the annual revenue surplus, and thus the
accumulation of Trust Fund surpluses. Reducing the Trust Fund surplus, absent other
changes to the program, would hasten the date of Social Security insolvency. If the funds
carved-out of Social Security taxes exceed the annual Social Security revenue surplus, it
would hasten the date of insolvency further, because not only would the Trust Funds stop
accumulating additional surpluses, but Trust Fund bonds would have to be redeemed to
cover benefit payments to current recipients. In order to offset the revenue lost to the
Social Security Trust Funds by carving out part of the Social Security tax and directing
it into individual accounts, additional revenues would have to be raised either through
increased taxes, reductions in government spending, or increased government borrowing.
Transition costs are not unique to individual accounts funded by a carve-out of
Social Security taxes. There would also be transition costs to a system of “add-on”
individual accounts, where all revenues dedicated to financing the current-law system
continue to go for that purpose. As with the carve-out accounts, contributions to fund
add-on accounts would have to be raised through increased taxes, reductions in
government spending, or increased government borrowing.
Under both a carve-out system and an add-on system of IAs, additional revenues
must be found to fund the accounts. Under a carve-out system, revenues are needed to
continue to fund current-law benefits or reimburse the Trust Funds as a result of the
3 Pre-funding can be accomplished in a number of ways, not only through IAs. For example, if
Social Security’s Trust Funds were invested in the market directly, the surpluses would no longer
be spent by the government and the government could redeem real assets to pay benefits in future
years.
4 Not all individual accounts would necessarily entail transition costs; however, these plans are
financed on a PAYGO basis and do not achieve pre-funding of benefits. For example, in a
“notional” account system such as the one in Sweden, the taxes paid in by today’s workers are
still paid out as benefits to current retirees. The difference between this IA system and the IA’s
being proposed in the U.S. is that, instead of actually taking contributions and investing them,
the system uses a “virtual account” that records the contributions and tracks what the growth
would be had they been invested. Then, when the individual retires, the IA is paid out as if it had
actually been invested and earned interest. To offset the additional cost to the government of
paying out possibly higher returns on the contributions, these plans often simultaneously reduce
the traditional defined benefit at retirement. Because no new revenues are needed to fund the
IAs, there are no up front transition costs.

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revenues diverted to fund the IAs. Under an add-on system, there is no additional cost to
the current Social Security system, but new revenues still would be needed to fund the IAs
directly. In both cases, the revenues needed to fund the IAs represent an additional cost
to the government as a whole, to individuals, the economy or all three, depending on the
source of the contributions.
How Large are the “Transition Costs”?
The size of the transition costs will depend on the number of individuals who
participate in the system and the amount contributed to the individual accounts. The
greater the number of people participating, and the larger the contribution to the accounts,
the greater the transition costs will be. In recent months, numerous press reports have
cited transition costs of approximately $1 trillion-$2 trillion over a 10-year period. The
President has not yet proposed a specific reform proposal, but some have suggested that
the starting point for discussion would be “Model 2” of the 2001 Presidential Commission
to Strengthen Social Security. Model 2 would permit workers to contribute an amount
equal to 4% of their OASDI taxable earnings ($87,900 in 2004), up to $1,000 (indexed
to wages after 2002) into an individual account.5 The SSA’s actuaries estimated in 2001
that the government would have to contribute $750 billion to $1.2 trillion over the first
decade (in constant 2003 dollars) in order to fund the individual accounts, depending on
whether 67% or 100% of eligible workers participated in the accounts, respectively.6
Some have argued that the $1 trillion-$2 trillion needed to transition to a system of
individual accounts is small relative to the unfunded liability of the current system, cited
in many newspaper articles as nearly $11 trillion.7 However, this comparison is
misleading since the $1 trillion-$2 trillion figure is an estimate of the transition costs over
10 years, while the nearly $11 trillion ($10.4 trillion) figure is an estimate based on
funding the program on an infinite horizon. In order to obtain a valid comparison of the
costs of making the transition to a system of individual accounts relative to the costs of
maintaining the current system, the period upon which the comparison is made must be
equal and the costs must be discounted over time. The Social Security actuaries have
estimated that the present value of the current-law unfunded obligation is $3.7 trillion
over the 75-year actuarial period that is the basis for all of their reform estimates.8 The
unfunded obligation is the difference between benefits which have been promised under
current law and those that the system will be able to pay from current-law revenues. By
comparison, over the same 75-year period, the net present value of the costs of the
individual accounts proposed in Model 2, excluding any reductions to current-law benefits
that are not a condition of participating in the individual account system, range from $1.5
5 Model 2 also included a number of changes to the Social Security defined benefit. For
additional information on Model 2, please see CRS Report RS21095, Social Security: Report of
the President’s Commission to Strengthen Social Security, by Dawn Nuschler.
6 SSA, Office of the Chief Actuary, Memorandum to Daniel Patrick Moynihan and Richard D.
Parsons, Co-Chairs, President’s Commission to Strengthen Social Security, Jan. 31, 2002.
7 For example, see “Bush Rules Out Higher Payroll Tax for Social Security,” The Wall Street
Journal, Dec. 10, 2004.
8 This estimate is of the OASDI program on an “open group basis,” meaning that it takes into
account all contributions and benefits paid to past, current, and future participants through 2078.

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trillion to $2.2 trillion, depending on the level of participation in the accounts. Thus, the
difference in costs is not the difference between $1 trillion-$2 trillion and $10.4 trillion,
but the difference between $1.5 trillion-$2.2 trillion and $3.7 trillion.
Will Transition to an Individual Account System Result in
Savings to Social Security?

Some observers have argued that the transition costs for a new system of individual
accounts is small relative to the contributions these accounts could make to Social
Security solvency in the very long-run.9 Others argue that the individual accounts simply
make the solvency situation worse.10 One reason for these differing conclusions may be
the time-frame used for the analysis. The SSA Actuaries selected a 75-year period for
analysis of the program’s solvency because it was felt that this was generally long enough
to cover the anticipated retirement years of those currently in the work force. Others,
including the President’s Commission, have argued that the 75-year period does not take
into account the projected current-law insolvency and the potential benefits of IAs in the
76th year and beyond. They propose using either a longer measurement period or an
alternate accounting method such as an increasing ratio of the number of years of benefits
that can be funded at the end of the actuarial period.
Most Social Security reform proposals would reduce Social Security benefits for
those who participate in an individual account. In many cases, including Model 2, the
increased value of the individual account itself does not reduce the unfunded liability of
the current system. The savings come from additional reductions in the Social Security
benefits that individuals will receive if they have participated in an IA, regardless of the
type of investment and the actual rate of return earned. These reform proposals rely on
these “benefit offsets” to pay for the up-front transition costs and reduce the costs of the
Social Security system. However, as is evident from Table 1, over the 75-year period
used by the Social Security actuaries to evaluate the system’s solvency, many individual
accounts would make the solvency problem worse. During this period, the benefit offsets
are not large enough to cover the IA transition costs. Thus, it would be inaccurate to
portray policymakers’ choices as either the current-law unfunded liability or the IA
transition cost. The cost of the transition to individual accounts is separate from — and
in addition to — the system’s current unfunded liability over this period. For example,
with just the individual account component, the 75-year unfunded liability under Model
2 would increase from $3.7 trillion to $5.2 trillion or $6.0 trillion.
However, beyond the 75-year actuarial period, these “benefit offsets” could improve
Social Security solvency. The main reason for the delay in realizing these savings is the
time it would take for participants in the IA system to retire. For example, a 21-year old
worker who enters the workforce in 2004 and contributes to an IA will not receive Social
Security benefits until 2045 at the earliest. Thus, while the costs of funding the IA are
immediate, the benefit offset designed to pay for funding the IA will not be realized until
many years into the future. We are unable to provide an estimate of an IA’s contribution
9 For example, see “Final Report of the President’s Commission to Strengthen Social Security.”
10 For example, see “Would Borrowing $2 Trillion for Individual Accounts Eliminate $10 Trillion
in Social Security Liabilities?,” the Center on Budget and Policy Priorities, Dec. 13, 2004.

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to solvency in the very long run because the official Social Security Administration
actuarial analysis stops at 75 years. However, in most cases, by the 75th year of the IA the
annual benefit offsets resulting from the IA are large and increasing. To the extent that
the present value of future benefit reductions exceeds the present value of the up-front
additional costs of the IAs over a longer time horizon, the accounts could contribute to
reducing the unfunded liability of the current Social Security system.
Table 1. Effect on Solvency of Individual Account Component of
Reform Proposals in the 108th Congress
Social Security Reform Proposals
Net Present Value of Transition to IA
(President’s Commission, Selected
over 75 Years
108th Congress)
( in constant 2003 dollars)
Unfunded liability of current-law system
$3.7 trillion
Change in current-law unfunded liability
(+ represents an increase in liabilities
due to IA:
and - represents a decrease in liabilities)
President’s Commission to Strengthen
+ $1.5 trillion
Social Security — Model 2 (67%
participation in IA)
President’s Commission to Strengthen
+ $2.2 trillion
Social Security — Model 2 (100%
participation in IA)
H.R. 75 (Representative Shaw)
- $0.8 trillion
H.R. 3821 (Representative Kolbe and
+ $4.6 trillion
Representative Stenholm)
H.R. 3177 (Representative DeMint)
+ $1.0 trillion
S. 1878 (Senator Lindsey Graham)
+ $2.6 trillion
H.R. 4851 (Representative Paul Ryan)
+ $1.5 trillion
Source: Congressional Research Service calculations based on actuarial memoranda from the Social
Security Administration’s Office of the Chief Actuary available at [http://www.ssa.gov/OACT/solvency/
index.html].
Notes: To isolate the net effects of the IA from the remainder of the reform proposal, the calculation counts
as a transition cost the dollars put into the IA by the government and subtracts any dollars taken from the
IA to help pay benefits over the 75-year actuarial period. This difference is the net transition cost. These
costs are then calculated in present value terms in order to take account of the discounted future value of
money. This present value calculation assumes that transfers to (costs) and from the IA (offsets) are made
at the end of the year, and assumes a real interest rate of 3%, which is consistent with the intermediate
assumptions of the 2003 and 2004 Trustees Reports. In the cases of reforms introduced in 2001 or 2002,
the cost and savings streams were first converted from constant 2001 or 2002 dollars into constant 2003
dollars using the CPI-W.