The Heritage Foundation

Backgrounder #1279

May 10, 1999

May 10, 1999 | Backgrounder on

Kolbe-Stenholm Proposal: A Firm Foundation for Social Security Reform

The 21st Century Retirement Security Act, which was introduced recently by Representatives Jim Kolbe (R-AZ) and Charles Stenholm (D-TX), offers a firm foundation for Social Security reform. It contains three crucial elements that will be necessary for true reform: It is bipartisan; it would take steps to reduce Social Security's unfunded liability; and it would allow workers to divert a portion of their existing Social Security taxes into a personal retirement account that they would own. This last feature would allow Americans to accumulate a cash nest egg for retirement and improve the rate of return on their Social Security taxes. There are several ways, however, that Congress could strengthen and improve the proposal.

The Kolbe-Stenholm plan would require each worker under age 55 to set up an Individual Security Account (ISA) funded with an amount equal to 2 percent of income. This money would be diverted from the Social Security retirement taxes that the worker must pay currently. It would go to an agency, similar to that which currently runs the federal employees' retirement system, through which the funds could be invested in stocks, bonds, or government debt. The individual worker would own the account; and, if he or she died before retirement, the full amount in it would go into that worker's estate.

The legislation also proposes gradually lowering traditional Social Security retirement benefits that future retirees would receive, in line with the reduction in their payroll taxes. Thus, under all circumstances, future retirees would receive both the benefits generated from their ISAs and the monthly payments from Social Security financed by their payroll taxes. In addition, current plans to raise the retirement age to 67 would be accelerated slightly and the bend points in the formula that Social Security uses to calculate retirement benefits gradually would be lowered. Finally, the computation period for benefits would be raised slowly from the current highest 35 years of earnings to the highest 40 years of earnings; and there would be a temporary change in the cost-of-living adjustment while the Bureau of Labor Statistics (BLS) recomputes the consumer price index (CPI).

On retirement, the worker could either annuitize the money in his or her ISA or take a phased withdrawal. Alternately, the worker could take, as a lump-sum benefit, any money left in the account after he or she had purchased an annuity that would pay at least a poverty-level benefit. The annuity would guarantee that the worker never would have to rely on the government for basic support. The Kolbe-Stenholm plan would include more generous benefits for spouses and a graduated government match of the money low-to-
moderate income workers save in their ISAs in addition to the mandatory amount diverted from their Social Security taxes. Finally, there is a guaranteed and enhanced minimum benefit that would protect workers from poverty.

CONDITIONS FOR TRUE SOCIAL SECURITY REFORM

Although it is not a perfect bill, the Kolbe-Stenholm plan meets many of the necessary conditions for true Social Security reform. These include:

  • Personal accounts would be funded with a portion of existing Social Security taxes.
    Instead of creating a new entitlement program, the Kolbe-Stenholm plan would reform the existing Social Security system by directing 2 percent of earnings into ISAs. This would ensure that workers will not be required to pay additional taxes for their current benefits.

  • Workers would own and benefit from their individual accounts.
    Instead of the government's seizing all or a major portion of a worker's ISA, Kolbe-Stenholm would allow workers to keep the full benefits of their savings. Also, if they died before retiring, workers could leave their accounts to their heirs.

  • Existing benefits would be reduced in line with the contributions to ISAs.
    The Kolbe-Stenholm plan is fiscally responsible. It would allow Americans to obtain the large potential benefits of personal investment by reducing a portion of the taxes and benefits associated with traditional Social Security. Thus, traditional low-return Social Security retirement benefits will be reduced gradually at the same time that the higher-return benefits generated from the ISAs will be on the rise. Because workers would receive both the reduced traditional benefits and benefits from their ISAs, they could look forward to a better standard of living during retirement, even as Social Security's huge unfunded liability gradually is being reduced. The enhanced minimum benefit, however, would guarantee that no worker faces a retirement below the poverty line.

  • The surplus would be used responsibly to achieve reform of the system.
    Unlike some other proposals that would use the surplus just to shore up the existing system, the Kolbe-Stenholm plan would use the surplus to finance a true reform that would improve the income of future retirees. It also would ensure that the reformed system would remain financially healthy for future generations.

  • The rate of return on Social Security taxes would improve.
    Because workers would be able to invest their ISAs in stocks and bonds that pay much higher returns than the current Social Security system pays, their rate of return would improve. Instead of receiving an average annual return of about 1.2 percent a year on their Social Security taxes, the amount invested in ISAs could earn an average of 7 percent a year after inflation. Even the lowest-risk investments, such as government bonds, still would give a return that greatly exceeds Social Security's low returns.

  • The plan is bipartisan.
    Any reform supported by Members from just one political party cannot pass Congress and be signed by President Bill Clinton. In addition to the sponsors, this legislation is cosponsored by Representatives Nick Smith (R-MI), Karen McCarthy (D-MO), Mark Sanford (R-SC), and Cal Dooley (D-CA). A similar bipartisan plan is being developed in the Senate.

ADDITIONAL IMPROVEMENTS

Although the Kolbe-Stenholm bill would provide a firm foundation for true Social Security reform, it is not a perfect bill. The legislation could be strengthened and improved if Congress were to:

  • Increase investment options.
    The Kolbe-Stenholm plan would require workers to invest their ISAs through a federal agency. Although this should be one option, workers should also be able to invest their ISA through a traditional financial services provider, such as a mutual funds company, bank, credit union, or broker.

  • Protect workers from a temporary adjustment in the CPI that may be too high.
    Although the Bureau of Labor Statistics plans to re-estimate the CPI, in the interim Kolbe-Stenholm would mandate a temporary 0.3 percent reduction. If the BLS re-estimate were smaller than this 0.3 percent reduction, the difference should be refunded to the worker.

  • Review regularly the government match of workers' savings.
    It makes little sense to reform one entitlement program and create a new one at the same time. Although there are good arguments for some level of government's matching of additional savings for low-to-moderate income workers, this feature needs to be crafted carefully to avoid its growing into an entitlement program that later would have to be reformed.

CONCLUSION

The Kolbe-Stenholm proposal takes a very positive step toward serious Social Security reform. It would be fiscally responsible and make many of the hard decisions that will be necessary to prevent Social Security's impending insolvency. Most important, it would allow workers of all income levels to build a next egg for retirement and to benefit more fully from the continuing growth in the U.S. economy.

David C. John is Senior Policy Analyst for Social Security in the Domestic Policy Studies Department at The Heritage Foundation.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies