The decision to create a Social Security system that includes personal retirement accounts, which would allow workers to invest a portion of their existing Social Security taxes in a personally owned account, is only the first step toward improving Americans' retirement security. Congress will have to determine how these accounts should be structured and regulated. More than anything else, such decisions will determine whether personal retirement accounts reach their full potential of increasing retirement income without unreasonable levels of investment risk.

Where would the money come from?
There are only two realistic sources for the funds that would go into a personal retirement account that is part of Social Security: the existing Social Security taxes that an individual already pays or new taxes.

Some lawmakers propose introducing new taxes or earmarking revenue from the expected budget surpluses to fund the new accounts. These are usually called "add-on" accounts because the money that goes into them is in addition to the taxes an individual already pays to Social Security. This method would mean higher taxes and would do nothing to improve an individual's rate of return on Social Security taxes.

The alternative is to fund the account with money that has been "carved out" or diverted from the taxes that now pay for Social Security retirement benefits. This method would make Social Security a much better deal for most Americans. In addition, diverting part of the existing Social Security tax would provide a much more stable source of funding that does not depend on the accuracy of economic forecasts or the ability of Congress to restrain its spending habits.

How would accounts be structured?
A simple system of personal retirement accounts would give workers the ability to choose from a limited number of investment choices while also allowing them to choose a qualified firm to manage those investments. Initially, in order to reduce administrative costs and potential investor confusion, it should offer only three low-cost investment options: a broad-based stock index fund, a corporate bond index fund, and some sort of government bond fund, perhaps using the new inflation-indexed Series I U.S. Savings Bonds.

Because the hundreds of billions of dollars in personal retirement accounts would almost certainly become too large an amount to be managed by any single investment manager, individuals should be allowed to purchase their stock or bond index funds from an approved list of investment managers. If the manager is unsatisfactory for any reason, account owners should be allowed to change to another firm at least annually.

How would accounts be regulated?
The long-term success or failure of personal retirement accounts would depend in large part on how they are regulated. Only established investment managers who can meet four strict, but objective, standards should be allowed to accept retirement savings. These standards are:

• Capital adequacy. The investment manager should have sufficient capital invested in the firm to ensure stability and the ability to survive market fluctuations.

• Professional expertise. Only qualified and experienced professionals should be allowed to manage these retirement savings accounts.

• Disclosure of fees. All fees and costs must be clearly disclosed in writing before any money is accepted.

• Regular statements. All account owners must receive regular statements in clear and simple language that discloses the status of their accounts, including the amount of contributions, the investment options chosen, the rate of return for each investment option, and the exact amount of any fees that were paid.

Because regulatory agencies tend to lack the technical knowledge needed to fully understand types of financial institutions beyond those that they regulate, the primary regulator of the financial institution owning the investment manager should handle the regulation of personal retirement accounts. To ensure that all types of financial institutions have an equal chance to compete for these accounts, and to ensure equal levels of consumer protection, a federal coordinating council should be established for personal retirement account regulators. Its primary responsibility would be to determine the basic structure of the regulations and issue them for public comment.

The Social Security Administration should have no role in regulating financial institutions that manage personal retirement accounts. A massive bureaucracy that can take years to determine eligibility for disability claims simply does not have the expertise or ability to understand the innovative and rapidly changing financial world. In addition, allowing the agency that administers the existing system to control its competition would be a conflict of interest.

Personal retirement accounts could allow every worker to participate fully in the growth of the American economy. However, in order to take full advantage of this opportunity, the accounts must be funded from a portion of the existing taxes that go to pay for Social Security retirement benefits. In addition, the structure and regulation of these accounts will make the difference between improved retirement income and unmet expectations.

David C. John is Senior Policy Analyst for Social Security at The Heritage Foundation. He is the editor of Improving Retirement Security: A Handbook for Reformers(The Heritage Foundation, 2000).