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.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
8906.
Length: Date of creation: Apr 2002 Date of revision: Handle: RePEc:nbr:nberwo:8906
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Mehra, Rajnish & Prescott, Edward C., 2003.
"The equity premium in retrospect,"
Handbook of the Economics of Finance,
in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 14, pages 889-938
Elsevier.
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George M. Constantinides, 2002.
"Rational Asset Prices,"
NBER Working Papers
8826, National Bureau of Economic Research, Inc.
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George M. Constantinides, 2002.
"Rational Asset Prices,"
Journal of Finance,
American Finance Association, vol. 57(4), pages 1567-1591, 08.
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