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

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  • George M. Constantinides
  • John B. Donaldson
  • Rajnish Mehra

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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8906.

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Date of creation: Apr 2002
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Publication status: published as Constantinides, G. M., J. B. Donaldson and R. Mehra. "Junior Must Pay: Pricing The Implicit Put In Privatizing Social Security," Annals of Finance, 2005, v1(1,Jan), 1-34.
Handle: RePEc:nbr:nberwo:8906

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  1. Andrew B. Abel, 2002. "The effects of a baby boom on stock prices and capital accumulation in the presence of Social Security," Working Papers 03-2, Federal Reserve Bank of Philadelphia.
  2. repec:fth:calaec:4-98 is not listed on IDEAS
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  6. George M. Constantinides & John B. Donaldson & Rajnish Mehra, 2002. "Junior Can'T Borrow: A New Perspective On The Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(1), pages 269-296, February.
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  10. John Y. Campbell & Martin Feldstein, 2001. "Risk Aspects of Investment-Based Social Security Reform," NBER Books, National Bureau of Economic Research, Inc, number camp01-1, July.
  11. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
  12. Mehra, Rajnish & Prescott, Edward C., 2003. "The equity premium in retrospect," Handbook of the Economics of Finance, Elsevier, 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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Cited by:
  1. Lee Redding, 2006. "Social Security Reform and Corporate Governance," Journal of Economic Policy Reform, Taylor & Francis Journals, Taylor & Francis Journals, vol. 9(3), pages 235-246.
  2. Stavros Panageas, 2009. "Bailouts, the Incentive to Manage Risk, and Financial Crises," NBER Working Papers 15058, National Bureau of Economic Research, Inc.
  3. Panageas, Stavros, 2010. "Bailouts, the incentive to manage risk, and financial crises," Journal of Financial Economics, Elsevier, Elsevier, vol. 95(3), pages 296-311, March.
  4. John Y. Campbell & Yves Nosbusch, 2007. "Intergenerational risksharing and equilibrium asset prices," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 24484, London School of Economics and Political Science, LSE Library.
  5. Bossi, Luca, 2008. "Intergenerational risk shifting through social security and bailout politics," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 32(7), pages 2240-2268, July.
  6. George M. Constantinides, 2002. "Rational Asset Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 57(4), pages 1567-1591, 08.
  7. Marianna Brunetti & Costanza Torricelli, 2010. "Demographics and asset returns: does the dynamics of population ageing matter?," Annals of Finance, Springer, Springer, vol. 6(2), pages 193-219, March.

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