September 10, 2001

September 10, 2001 | Backgrounder on Social Security

The New Kolbe-Stenholm Plan: A Solid Framework for Reforming SocialSecurity

H.R. 2771, 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 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 H.R. 2771.

THE NEW KOLBE-STENHOLM PROPOSAL

This most recent version of the Kolbe-Stenholm plan is an improvement over the versions that have been introduced in the past two Congresses. The new Kolbe-Stenholm creates a progressive contribution formula for its personal retirement account portion, known as individual security accounts (ISAs). All workers under the age of 55 would be required to open an ISA. Instead of allowing all workers, regardless of income, to contribute the same proportion of income to such an account, H.R. 2771 would allow workers to contribute 3 percent of their first $10,000 of income plus 2 percent of the amount over that to the personal account, thereby effectively increasing the ability of lower-income workers to build wealth in their accounts.

In addition, workers would be able each year to contribute up to $5,000 to their ISAs voluntarily out of their annual earnings. Some of these additional contributions would earn tax credits toward their income taxes.

The money that goes into an individual's ISA would be diverted from the Social Security retirement taxes that the worker currently must pay. It would go to an agency, similar to the one that now runs the federal employee retirement system, through which the funds could be invested in stocks, bonds, or government debt.

Once the account reached $7,500 in assets, the worker would have the option to move his or her account to an approved private manager. If this proved to be unsatisfactory to the worker, he or she would also have the option to move the ISA back to the funds managed through the federal agency. In all cases, 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.

In addition to the ISA, workers would receive benefits through the traditional version of Social Security. Under all circumstances, future retirees would receive both the benefits generated from their ISAs and the monthly payments from Social Security financed by the rest of their payroll taxes. Effectively, this dual benefit system would be similar to designating the traditional benefit structure of Social Security Part A, while the ISA would become a Social Security Part B.

There are three ways to reduce or eliminate Social Security's future fiscal problems: Reduce retirement benefits, raise taxes, and allow workers to increase their rate of return by investing part of their taxes in an account similar to Kolbe-Stenholm's ISA.

Although H.R. 2771 does not increase taxes, it does include significant benefit reductions in addition to the gains from its ISA. These benefit reductions would primarily affect upper-income retirees, but some, including the COLA reduction, could affect lower-income retirees as well. Since almost all upper-income workers will have the opportunity to build retirement savings through private pension plans such as 401(k) plans, Kolbe-Stenholm's benefit reductions should not materially affect their retirement incomes. Additional improvements in the proposal would be needed to safeguard lower-income workers.

The legislation proposes gradually lowering traditional Social Security retirement benefits that future retirees would receive. For instance, current plans to raise the retirement age to 67 would be accelerated, and the bend points in the formula that Social Security uses to calculate retirement benefits would gradually be lowered.

Also, 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 0.33 percent reduction in the cost-of-living adjustment while the Bureau of Labor Statistics (BLS) recomputed the consumer price index (CPI). If the BLS changes in the CPI did not equal at least a reduction of 0.33 percent, H.R. 2771 would require at least that level of reduction. H.R. 2771 would also increase Social Security revenue by gradually changing the way that the tax base is indexed.

Upon retirement, the worker could either annuitize the money in his or her ISA or take a phased withdrawal. Alternatively, 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 would never have to rely on the government for basic support. The Kolbe-Stenholm plan would include more generous benefits for spouses and would shield Social Security's disability insurance program from being affected by any of the benefit reductions in the retirement program. 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. Specifically:

  • 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 3 percent of the first $10,000 in earnings and 2 percent of the rest into ISAs. This would ensure that workers would 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.
  • Retirement benefits would consist of both traditional benefits and earnings from ISAs. The Kolbe-Stenholm plan is fiscally responsible. It would allow Americans to obtain the potential benefits of personal investment by replacing a portion of the traditional low-return Social Security retirement benefits with the higher-return benefits generated from ISAs. 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 is gradually being reduced. The enhanced minimum benefit would guarantee that no worker faces a retirement below the poverty line.
  • 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, they could earn an average of 7 percent a year (after inflation) on the amount invested in their ISAs. 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. No reform supported by Members from just one political party can pass Congress and be signed by President George W. Bush. In addition to the primary sponsors, this legislation is cosponsored by Representatives Nick Smith (R-MI), Cal Dooley (D-CA), and Pat Toomey (R-PA).

FURTHER STEPS ARE NEEDED

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

  • 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 0.33 percent reduction. Rather than legislatively mandating a minimum CPI reduction, if the BLS re-estimate were smaller than this 0.33 percent reduction, the difference should be refunded to the worker.
  • Review regularly the transfer of general revenues. One weakness of Kolbe-Stenholm is that it requires constant general revenue transfers to keep it in balance. Starting in 2002, general revenues equal to 0.13 percent of taxable wages (about $5 billion in today's dollars) would be shifted to the Social Security trust fund. This amount would rise to 0.80 percent of taxable wages (about $31 billion) by 2066. As time goes on, it should be possible to replace this subsidy by gradually increasing the size of the ISA or through other means.

CONCLUSION

The Kolbe-Stenholm proposal represents a very positive step toward serious Social Security reform. It would be fiscally responsible and would 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 nest egg for retirement and benefit more fully from the continuing growth in the U.S. economy.

 

David C. John is Senior Policy Analyst for Social Security 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