If the levels of benefit cuts and tax increases required to maintain the current pay-as-you-go system are not feasible, is there an alternative? The answer is yes. Here is why:

• If three percentage points of the current 12.4 percent payroll tax paid by 22-year-old workers were invested annually in earning assets (stocks and bonds) for the remainder of their working lives, the value of that investment would roughly equal the benefits a 22-year-old worker is currently promised by the Social Security system.

• The estimated average annual federal budget surplus over the next decade - $215 billion - will more than pay for the annual transition cost of allowing workers to opt into an Investment-Based Social Security system.

• An investment-based solution to the Social Security crisis has already been tested in other countries, and it works.

More than half a dozen countries have discarded the Bismarck system and replaced it in total or in part with an investment-based system. Australia did it under a left-leaning labor government; Britain did it first under a Labour Government and expanded it under Margaret Thatcher; and Chile did it as a developing country. In each case, benefits have become more secure and average retirement incomes have risen.

Creating an Individual Investment Alternative. On January 1 of the year 2000 every worker holding a Social Security card will be given a choice. They can enter the investment-based system or stay in the current system. Those acquiring a Social Security card after January 1, 2000, will automatically enter the new system. Those electing to remain in the current system can choose to enter the new system at any point during their working lives. Those entering the investment-based system will be guaranteed retirement, survivor, disability and other benefits at least equal to those the current system provides.

All workers will continue to have 12.4 percent of their wages withheld by their employer. Just as under the current system, the employee will pay half of the withheld amount directly out of wages and half indirectly through the employer's contributions. But for those opting into the new system, three percentage points of that 12.4 percent will go not to pay benefits for current retirees or to fund general government but instead will be invested in real earning assets. Each worker will own his new investment account, which will be used solely to pay his retirement or survivor benefits.

Market Rates of Return. For the purpose of this analysis, the expected rate of return on investment is calculated by throwing out the high rates of return of the last five years as an aberration and focusing instead on the previous 67 years (including the Great Depression). Harvard economist Martin Feldstein and Dartmouth economist Andrew Samwick in a National Bureau of Economic Research study have calculated the historical rate of return on an investment portfolio consisting of 60 percent stocks and 40 percent bonds from 1926 through 1992. ² They found that the average rate of return to investors was 5.5 percent in real, after-inflation, dollars. ³

While total return on the investment accounts is assumed to average 5.5 percent, as has been the historic norm, part of this return must be used to cover the administrative costs of managing the individual accounts. Many actively managed mutual funds have administrative loads as high as 1 percent of assets. But since funds set aside for Investment-Based Social Security will be held for long periods, a more appropriate model for estimating administrative costs would be the Thrift Savings Plan (TSP), which manages retirement funds for federal workers, or privately managed index funds such as the Vanguard Index 500 Fund or the Fidelity Spartan U.S. Equity Index Fund. The TSP funds carry an average administrative cost of 0.09 percent, or 9 basis points, while the privately managed index funds average 0.19 percent, or 19 basis points.

Under an Investment-Based Social Security system, fund managers will be required to assess the same percentage administrative charge on all investors, regardless of account size. This will result in low-income workers receiving an implicit subsidy from high-income workers, since certain fixed costs would apply to every account. Given these factors, the economic model used in this analysis assumes that Investment-Based Social Security accounts will have an average administrative cost of 0.2 percent, or 20 basis points, lowering the net return on the accounts to 5.3 percent per year. ⁴

Establishing Individual Ownership of Investments. The investments funded by the 3 percent contributions will be called Social Security Individual Investment Accounts or SI Accounts. Like today's Individual Retirement Accounts (IRAs), the SI Accounts will be owned by individual employees, with rights of property enforceable in the courts. No politician could ever touch the SI Accounts. No government interference will be permitted in directing or controlling investment decisions, other than the general guidelines established for safety and soundness purposes. This is a level of security totally absent under the current debt-based system. In Nestor v. Fleming (1960), the Supreme Court ruled that individuals have no right to Social Security benefits based on the taxes they have paid. Workers have a legal right only to what Congress chooses to give them, and the level of Social Security benefits in the future is no more secure than the willingness of Congresses not yet elected to raise taxes to pay for them.

The SI Accounts will be managed by private sector businesses called Qualified Social Security Individual Investment Funds (Qualified SI Funds). Qualified SI Funds will be certified by the federal government as meeting rigorous financial and operating standards. Individual workers will choose the specific fund to manage their SI Account, just as workers today choose where to place their IRAs. Qualified SI Funds will compete based on their rate of return, customer service, commissions charged and guarantees provided.

The Qualified SI Funds will invest the assets of the SI Account in stocks, bonds, bank deposits, insurance instruments, annuities and other earning assets, within strict safety and soundness parameters set by federal regulators. The only direct involvement of the worker in choosing his investments will be in his choice of a Qualified SI Fund to manage those investments.

An entry on participating workers' paycheck stubs will show exactly how much money was invested in their SI Account for that pay period. At least once per year, the Qualified SI Funds will be required to provide a Social Security Investment Status Report to every participant. The report will show the dollar value of investments made over the last quarter, the last 12 months and the life of the SI Account, as well as the rate of return earned over each period. The SI Status Report will also provide a projection of how much each worker will have at retirement if contributions and earnings continue at the same rate during the remainder of his or her working years. Earning rates achieved by all qualified SI funds will be made public quarterly, and workers will have a right once a year to switch their SI Accounts from one Qualified SI Fund to another.

Ensuring Safety and Soundness. In the investment-based system, workers' retirement income is secured by actual investment of their savings, in their own name, in genuine earning assets. Any action by government to take SI Account funds will be blocked by the "takings" clause of the Constitution.

Oversight and regulation of SI Accounts and the SI Funds that manage them will be the responsibility of a newly created Social Security Investment Board (SI Board). The board will include the Secretary of the Treasury, the Chairman of the Federal Reserve Board, the Chairman of the Securities and Exchange Commission and two members from the private sector. One private sector member will chair the SI Board. The two private sector members will be appointed by the president and confirmed by the Senate to serve for staggered terms of six years. They will be experts in finance, investments or insurance.

The SI Board will have several key responsibilities. It will establish the safety and soundness standards under which all SI Funds will be regulated and will certify those companies that qualify to sell SI Accounts. Furthermore, the SI Board will have the power to assess penalties, including decertification, against any SI Fund it determines to be in violation of its standards.

Additionally, the board will be responsible for establishing the parameters for sound diversification of investments. Initially, SI Accounts will hold no more than 60 percent of their investment portfolio in stocks, with no more than 3 percent of the portfolio invested in the stock of any one company. After two years, the SI Board can change that ratio to allow greater levels of equity investment for younger workers and smaller risk exposure for workers nearing retirement. The SI Board will set general parameters for the investment portfolio but will be prohibited from directing the selection of the actual investments. ⁵

Each individual worker owns the funds in his or her SI Account. Upon retirement, the worker's SI Account will be supplemented by the current system if the amount of monthly income provided to the worker by his SI Account is less than what he would have received from the current system, plus a bonus of 20 percent. Younger workers who are in the investment-based system their entire lives will, on average, receive more than 120 percent of the benefits promised by the current system from their SI Accounts and therefore will not need a supplement from the current system unless they experience a lifetime of low wages or long periods of unemployment. Workers who enter the investment-based system late in their working lives will not have sufficient time to build up a large SI Account, so they will receive a supplement from the current system. The supplement will be calculated so that the worker's total monthly benefit equals the amount promised by the current system plus 20 percent of the annuitized value of the SI Account.

Retirement Annuities. Workers who choose to participate in the new, Investment-Based Social Security system will, upon reaching retirement age, be required first to use their investment funds to buy a Social Security Individual Investment Annuity (SI Annuity). To qualify, an SI Annuity will have to provide a monthly income that is guaranteed for the remainder of the retiree's life. ⁶ The SI Board will set standards for SI Annuities, which their sellers will be required to meet.

When the investment-based system is fully phased in, each retiree will be required to purchase an SI Annuity that provides a monthly payment equal to the Social Security benefit promised under current law plus 20 percent. Any funds in the retiree's SI Account above that amount can be withdrawn by the retiree in total or in part and used for any purpose. ⁷ The gains that will accrue to the SI Account over the life of the investment will not be subject to taxation until the employee retires. The income received from the SI Annuity will be treated for tax purposes like income received from the current Social Security system. Any funds in an SI Account not used to purchase the required SI Annuity or pay for other current law benefits will be taxed as investment income at the time of withdrawal.

Retirement Benefits under the New System. Consider a 20-year-old worker who begins in the year 2000 to invest three percentage points of his 12.4 percent payroll tax in an SI Account. Suppose that the worker's wages over his working life average $30,000 a year, adjusted for inflation. Based on historic rates of return, the worker can expect a net average annual real rate of return of 5.3 percent, net of management fees. When the worker reaches age 67,⁸ his SI Account will be valued at $175,372 - allowing him to purchase a Social Security Annuity paying $15,486 annually, which is 23 percent more than the $12,585 the current Social Security system would have provided.⁹ If a young worker enters the labor force after the year 2000 and due to low wages or unemployment builds up an SI Account insufficient to pay the promised benefit of 20 percent of his SI Annuity plus the current Social Security payment, the Social Security system will supplement his SI Annuity by the amount required to provide the guaranteed benefit. The same guarantee will apply to any worker whose SI Account earnings are insufficient to pay the 20 percent bonus and the benefit that could be expected under the existing Social Security system.

Retirement Benefits during the Transition. During the transition period, those workers who are older when they join the new system will have a shorter period of time to invest before reaching retirement age. As a result, funds in their SI Account will be insufficient to fully fund their retirement. In such cases, the workers will draw retirement benefits in part from the existing Social Security system and in part from their own SI Annuities.

For example, a 45-year-old worker who joins the investment-based system in 2000 and who has real average earnings of $30,000 will build up an SI Account of $33,249. This amount is large enough to purchase an annuity of only $2,936 per year. Yet the promised benefit under the current system is $12,585 a year. In addition, retirees in the investment-based system are guaranteed they will never receive less than they would have received under the old system plus 20 percent of the SI Account investment buildup. Under the transition plan, therefore, the worker will receive an annual retirement pension of $13,074. The extra $489 is the worker's bonus, which equals 20 percent of the amount of retirement benefits funded by his investment annuity. The investment annuity pays the $489 bonus and replaces $2,447 of tax-funded benefits, for a total of $2,936 per year. The remaining $10,138 per year will be paid from payroll taxes under the existing Social Security system. [See Table I.]

With each year that passes, new retirees will get an increasing share of their retirement income from their SI Annuities rather than from the existing Social Security system.¹⁰ Figure III shows how the percentage of Social Security benefits paid by the payroll tax declines over time for an average worker who earns $30,000 a year in inflation-adjusted dollars. Those retiring in 2000 will have built up no investments and their Social Security benefits will be paid entirely out of the existing Social Security system by payroll taxes. The first baby boomers (those retiring in 2015) will have built up an SI Account that will displace 10 percent of the Social Security benefit that would have been funded by payroll taxes and fund a 2 percent bonus as well. The 10 percent funded by the SI Account instead of payroll taxes is permanent and never again will workers have to pay a payroll tax to fund that portion of Social Security benefits for those retiring in 2015.

By 2024, the average worker earning $30,000 will have built up investments large enough to pay the 20 percent investment bonus, which will equal 5 percent more than his expected Social Security benefit, and still displace 25 percent of the cost previously borne by the payroll tax. By 2035, the last baby boomers' SI Accounts will fund a bonus equal to 10 percent of the Social Security benefit provided by the current system and displace 50 percent of the cost of funding current benefits. By 2047 and beyond, retirees will receive a full 20 percent investment bonus and their SI Accounts will fully fund their Social Security.

Freedom to Retire. In order to control the cost of federal retirement programs, the government has established 65 as the retirement age for workers who receive full benefits. When the Social Security system edged toward bankruptcy in the late 1970s, the government responded in 1983 with legislation that will gradually increase the retirement age from 65 to 67. Similarly, some are now proposing to raise the retirement age to 70. Under a fully implemented investment-based system, however, the worker rather than government will choose when to retire. Workers can retire at any age once they have built up a large enough SI Account to fund benefits equal to 120 percent of the Social Security benefit promised at the normal retirement age and fund any survivors, spousal or other benefits that might be triggered by their retirement.

Nothing in the Investment-Based Social Security system will alter the rules governing early retirement at age 62 under the current system. Workers who choose to participate in the investment-based system will have the right to retire at 62 with a benefit during the transition at least equal to their early retirement benefit under the current system plus 20 percent of their SI Fund.