Junior Must Pay: Pricing the Implicit Put in Privatizing Social Security

George M. Constantinides (), John B. Donaldson and Rajnish Mehra ()

No 8906, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Proposals that portion of the Social Security Trust Fund assets be invested in equities entail the possibility that a severe decline in equity prices renders the Fund assets insufficient to provide the currently mandated level of benefits. In this event, existing taxpayers may be compelled to act as insurers of last resort. The cost to taxpayers of such an implicit commitment equals the value of a put option with payoff equal to the benefit's shortfall. We calibrate an OLG model that generates realistic equity premia and value the put. With 20 percent of the Fund assets invested in equities, the highest level currently under serious discussion, we value a put that guarantees the currently mandated level of benefits at one percent of GDP, or a temporary increase in Social Security taxation of at most 25 percent. We value a put that guarantees 90 percent of benefits at merely .03 percent of GDP. In contrast to earlier literature, our results account for the significant changes in the distribution of security returns resulting from Trust Fund purchases. We also explore the inter-generational welfare implications of the guarantee.

JEL-codes: D91 E2 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mic
Date: 2002-04
Note: AG AP PE
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Journal Article: Junior must pay: pricing the implicit put in privatizing Social Security (2005)
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