CRS Report on Social Security Transition Costs

Several blogs are reporting an update (or perhaps simply the public release) of a 2007 Congressional Research Service policy paper on the transition costs associated with Social Security personal accounts. While any exploration of this tricky issue is welcome, this study – perhaps due to a desire to produce quantifiable results with limited data – unfortunately mischaracterizes the question.

“Transition costs” arise when a pay-as-you-go program is converted in part or whole to a pre-funded program. In a pay-as-you-go system today’s retirees are supported by today’s workers; in a funded system today’s retirees are supported by their own savings, accumulated during their working years.

Any effort to prefund future benefits involves transition costs, be it through “carve out” accounts funded out of the existing payroll tax, “add on” accounts funded on top of the payroll tax, or through investment of the Social Security trust fund in assets other than Treasury bonds. (I will discuss this latter case in a separate post).

But for simplicity, let’s stick to the common example where today’s workers invest part of their payroll taxes in personal accounts. Since Social Security is a pay-as-you-go program, today’s taxes are earmarked to pay today’s benefits. If part of those taxes are invested to pay tomorrow’s benefits, the system face a temporary shortfall. This shortfall, which declines and eventually disappears as workers with accounts begin to retire, is referred to as the transition cost. Intuitively, the larger the amount of prefunding – that is, the larger the accounts and the higher the share of workers who participate – the larger the transition cost.

Transition costs bring with them transition benefits. When workers with accounts retire, the tax rate needed to provide a given level of total benefits declines since part of those benefits are provided by the accounts, which were funded in the past.

Where things get difficult, and where the CRS report runs into problems, is when we attempt to quantify the transition costs of a given reform plan and compare to other plans. The CRS report defines transition costs as “the dollars put into the IA (Individual Account) by the government [minus] any dollars taken from the IA to help pay benefits over the 75-year actuarial period.”

While this definition sounds reasonable, it encounters several significant problems.

First, in any measure that consistently counts both the contributions to accounts and benefits paid from accounts (e.g., closed group or infinite horizon measures), the measured transition costs for any given cohort of participants will be negative so long as the accounts’ assumed returns exceeds those of the Social Security trust fund. This is simply because the account contributions would be compounded forward at a higher interest rate than they are discounted back at. This is unnecessarily generous to personal accounts: if accounts earn more than the riskless interest rate it is because they invest in riskier assets. In any case, it's not clear how netting benefits paid against account contributions relates to the intuitive view of transition costs.

Moreover, the net transition costs of reform plans can differ based upon the assumed interest rate earned by their personal accounts. Accounts with aggressive investment portfolios will pay more benefits and thus have lower transition costs than accounts with more conservative investments. The accounts in Kolbe-Stenholm, for instance, are invested in 50% stocks and 50% long-term Treasury bonds. With assumed returns of 6.5% and 3.0% and administrative costs of 0.3% of assets, the net projected return is 4.45%. The Ryan plan, on the other hand, assumes 65% investment in stocks and 35% in corporate bonds with administrative costs of 0.25%, for a projected net return of 5.2%. As a result, the Ryan plan has among the lowest transition costs and Kolbe-Stenholm the highest, despite the fact that Ryan’s accounts are twice as large as Kolbe-Stenholm’s. This conclusion simply seems wrong. (There may be other plan-to-plan measurement issues as well: it appears that for some plans the study counts the actual benefits paid out of personal accounts, while for others it counts the reductions in traditional benefits due to account participation. While related, these are not the same thing. In particular, cuts in traditional benefits for personal account holders are larger in plans with guarantees of receiving at least scheduled benefits. Without these guarantees most workers would not accept accounts on the terms presented. If so, however, then the cost of the guarantee would need to included.)

Second, countering the above methodological generosity is the use of a 75-year measurement period to calculate transition costs. In fact, the only reason any of the reform plans show any significant transition costs is due to measurement using a truncated 75-year period. Net transition costs are driven almost entirely by account contributions made during the 75-year period that are paid after the 75^th year. While one can argue about measuring system financing with a 75-year period or the infinite horizon, in this case the 75-year horizon seriously skews the results. And, as above, it’s not clear how this measure relates to the intuitive view of transition costs outlined above.

The problems presented above don’t imply that measuring transition costs is easy. The President’s Commission to Strengthen Social Security presented a measure of “transition financing” that stated:

In every year where financing needs are greater under the Reform Model than they would be under current law, that year is identified as a “transition year.” All required extra financing is added up for each transition year, and the sum is given on the table.

Under this definition, a reduction in the Social Security surplus due to personal account is not counted as part of a transition cost. In addition, if reductions in traditional benefit growth reduce the need for overall financing to the program, this also reduces measured transition costs. Again, it’s not clear that this measure hits on the intuitive notion of transition costs.