Among the elderly, Social Security income is distributed very differently than private pension and asset income. For the bottom quintile of the income distribution, 81 percent of income comes from Social Security, while only 6 percent is from pensions plus income from assets. For the top quintile, 23 percent comes from Social Security, while 46 percent is from pensions and assets - dramatically different percentages. Similarly, there are great differences in saving and investing among current workers. Among all those who were paying social security taxes in 1995, fully 59% held no stock, either directly or through pension plans. Even among those between 45 and 54 years of age, 50% held no stock, directly or indirectly. These differences have important implications for the proposal to invest part of Social Security trust fund reserves in private securities. This paper explores the equilibrium impact of social security trust fund portfolio diversification to include private securities. We evaluate the effects on relative prices, on welfare, and on investment. We use an overlapping-generations model with two types of representative agents, one of which does no saving (except through social security) and the other of which saves and adjusts her private portfolio in response to changes in rates of return (and, for simplicity is assumed not to be covered by social security). We refer to the two types of agents as workers and savers. In order to keep the analysis simple, social security is modeled as if it were a defined contribution system. Thus the analysis, although described in terms of trust fund investment, would hold equally well for social security individual accounts following the same investment strategy. The differences between defined benefit and defined contribution systems as distributors of rate-of-return risk have been explored in OLG models with a single representative agent. This paper is meant to complement those studies. There is a brief discussion of modeling a defined benefit plan in Section 9. Our major finding is that trust fund portfolio diversification into equities has substantial real effects, including the potential for significant welfare improvements. Diversification raises the sum total of utility in the economy if household utilities are weighted so that the marginal utility of a dollar today is the same for every household. The potential welfare gains come from the presence of workers who do not invest their savings on their own. If relative prices remain constant after diversification, as they would if there were constant marginal returns to all kinds of investment, then this represents a (weak) Pareto gain, since no households would lose and the workers would gain. Moreover, in this case expected output increases. In this paper we concentrate on a tractable special case in which there are constant marginal returns in short-term risky investments, but no safe real investment. In this case, diversification changes the safe rate of interest, leaving the (expected) risky rate of return unchanged. Diversification still achieves a (weak) Pareto gain provided the marginal responses of taxes to interest rate changes match debt holdings, and there are no long-lived assets. Without these assumptions, however, diversification may involve redistributions within or across cohorts, so that a Pareto gain might require additional policy steps. Without long-lived assets and assuming that savers bear at least as large a share of taxes as of interest receipts, diversification increases the safe rate of interest, reducing the equity premium, since the expected risky rate of return stays the same (given the assumption of constant marginal returns). In this case diversification also increases aggregate investment, assuming normality of demands. An increase in the safe rate, however, increases government interest payments on its debt and forces a change in taxes. Given our hypothesis that savers pay more in taxes than they receive in interest payments on their government debt, the increase in taxes hurts savers. The fall in the equity premium also reduces the apparent advantage to diversifying the social security trust fund, but does not alter the conclusion that at least for small investments in equities, it raises the welfare of the workers. Moreover, the increase in the bond rate of return actually improves the returns for the trust fund assets remaining in bonds, and thus brings a second benefit to workers, provided their tax increase is not larger. If, in addition, there are infinitely-lived assets like land (with the same risk characteristics) as well as the one-period assets, diversification still increases aggregate investment and raises the safe rate of interest. The rise in the safe interest rate reduces the price of land, redistributing wealth from the elderly, who hold the long-lived assets at the time of implementation of the policy, to later cohorts who buy the land. The welfare effect of diversification on young savers is now ambiguous, since young savers are likely to pay more income taxes due to the governmentís increased debt burden while gaining from the fall of land prices. Land prices unambiguously fall because of our assumption of constant returns in the risky sector. In our companion paper, where we permit decreasing returns, we find that this result is often reversed, depending on the elasticity of marginal returns in the risky and safe sectors of production. To illustrate how this could happen, we consider here a model with constant marginal returns in short-term safe real investment but no short-term risky investment. In this case the price of risky land rises, reversing the direction of redistribution across cohorts. Our analysis bears directly on assertions that Social Security Trust Fund investment in equities is not of value to the economy, assertions which do not recognize the issues of income distribution and risk bearing within a diverse cohort. This paper demonstrates that it is not adequate to consider trust fund policy in a representative agent model. Moreover, the analysis is relevant for assertions of those who consider only the potential return on individual accounts, ignoring the unfunded obligations of social security, the riskiness of equity investments, and the general equilibrium effects.
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John Geanakoplos & Olivia S. Mitchell & Stephen P. Zeldes, 2000.
"Social Security Money's Worth,"
NBER Working Papers
6722, National Bureau of Economic Research, Inc.
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