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Market Valuation of Accrued Social Security Benefits

  • John Geanakoplos
  • Stephen P. Zeldes

One measure of the health of the Social Security system is the difference between the market value of the trust fund and the present value of benefits accrued to date. How should present values be computed for this calculation in light of future uncertainties? We think it is important to use market value. Since claims on accrued benefits are not currently traded in financial markets, we cannot directly observe a market value. In this paper, we use a model to estimate what the market price for these claims would be if they were traded. In valuing such claims, the key issue is properly adjusting for risk. The traditional actuarial approach - the approach currently used by the Social Security Administration in generating its most widely cited numbers - ignores risk and instead simply discounts "expected" future flows back to the present using a risk-free rate. If benefits are risky and this risk is priced by the market, then actuarial estimates will differ from market value. Effectively, market valuation uses a discount rate that incorporates a risk premium. Developing the proper adjustment for risk requires a careful examination of the stream of future benefits. The U.S. Social Security system is "wage-indexed": future benefits depend directly on future realizations of the economy-wide average wage index. We assume that there is a positive long-run correlation between average labor earnings and the stock market. We then use derivative pricing methods standard in the finance literature to compute the market price of individual claims on future benefits, which depend on age and macro state variables. Finally, we aggregate the market value of benefits across all cohorts to arrive at an overall value of accrued benefits. We find that the difference between market valuation and "actuarial" valuation is large, especially when valuing the benefits of younger cohorts. Overall, the market value of accrued benefits is only 4/5 of that implied by the actuarial approach. Ignoring cohorts over age 60 (for whom the valuations are the same), market value is only 70% as large as that implied by the actuarial approach.

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File URL: http://www.nber.org/papers/w15170.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15170.

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Date of creation: Jul 2009
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Publication status: published as Market Valuation of Accrued Social Security Benefits , John Geanokoplos, Stephen P. Zeldes. in Measuring and Managing Federal Financial Risk , Lucas. 2010
Handle: RePEc:nbr:nberwo:15170
Note: AG AP EFG ME PE
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  1. John Geanakoplos & Stephen P. Zeldes, 2008. "Reforming Social Security with Progressive Personal Accounts," NBER Working Papers 13979, National Bureau of Economic Research, Inc.
  2. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  3. Deborah Lucas, 2007. "Valuing & Hedging: Defined Benefit Pension Obligations - The Role of Stocks Revisited," Money Macro and Finance (MMF) Research Group Conference 2006 169, Money Macro and Finance Research Group.
  4. Alexander W. Blocker & Laurence J. Kotlikoff & Stephen A. Ross, 2008. "The True Cost of Social Security," NBER Working Papers 14427, National Bureau of Economic Research, Inc.
  5. William Goetzmann, 2005. "More Social Security, Not Less," Yale School of Management Working Papers ysm449, Yale School of Management.
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