Junior must pay: pricing the implicit put in privatizing Social Security

George Constantinides, J. B. Donaldson () and Rajnish Mehra

Annals of Finance, 2005, vol. 1, issue 1, 34 pages

Abstract: Proposals that a portion of the Social Security Trust Fund assets be invested in equities entail the possibility that a severe decline in equity prices will render the Fund’s 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’s 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, 20 percent. We value a put that guarantees 90 percent of benefits at .03 percent of GDP. In contrast to the earlier literature, our results account for the significant changes in the distribution of security returns resulting from Trust Fund purchases. Copyright Springer-Verlag Berlin Heidelberg 2005

Keywords: Social Security Trust Fund; Privatized Social Security; Government warranties; Put options; Overlapping generations; D91; E2; E60; G11; G13; H55 (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (7)

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Working Paper: Junior Must Pay: Pricing the Implicit Put in Privatizing Social Security (2002)
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DOI: 10.1007/s10436-004-0002-7

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