This chapter compares funded Social Security with PAYGO (pay-as-you-go) Social Security. They have much in common. Each is a compulsory, universal, defined-benefit annuity plan with inflation protection: a retiree receives an annual benefit that is tied to the retiree's wage history by a legislated formula, continues for as long as the retiree (or spouse) lives, and is automatically adjusted annually for inflation. PAYGO and funded Social Security differ solely in financing.

Funded Social Security has a permanent capital fund that is large enough to make its investment income (along with payroll taxes) an important source of financing benefits. Because it lacks investment income, PAYGO Social Security requires tax revenue roughly equal to benefits. In contrast, funded Social Security requires tax revenue roughly equal to half of benefits, because its investment income also equals half of benefits. The capital fund is large enough to make the yield on Social Security saving comparable to the yield on low-risk private saving. The Social Security fund's broadly diversified portfolio of corporate stocks, corporate bonds, and government bonds is managed by private firms under contract with the Social Security Administration. This capital fund is accumulated by gradually opening up a gap between payroll taxes and benefits during a lengthy transition period, not by government borrowing. The expanded earned-income tax credit is used to protect low-income workers from the transitional tax burden.