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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.

Suggested Citation

  • George M. Constantinides & John B. Donaldson & Rajnish Mehra, 2002. "Junior Must Pay: Pricing the Implicit Put in Privatizing Social Security," NBER Working Papers 8906, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:8906
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    References listed on IDEAS

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    1. 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, Oxford University Press, vol. 117(1), pages 269-296.
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    Cited by:

    1. Marianna Brunetti & Costanza Torricelli, 2010. "Demographics and asset returns: does the dynamics of population ageing matter?," Annals of Finance, Springer, vol. 6(2), pages 193-219, March.
    2. Campbell, John Y. & Nosbusch, Yves, 2007. "Intergenerational risksharing and equilibrium asset prices," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2251-2268, November.
    3. Stavros Panageas, 2009. "Bailouts, the Incentive to Manage Risk, and Financial Crises," NBER Working Papers 15058, National Bureau of Economic Research, Inc.
    4. Francisco Azeredo, 2014. "The equity premium: a deeper puzzle," Annals of Finance, Springer, vol. 10(3), pages 347-373, August.
    5. Ponds, E.H.M. & van Riel, B., 2007. "The Recent Evolution of Pension Funds in the Netherlands : The trend to Hybrid DB-DC Plans and Beyond," Other publications TiSEM 678caf10-ac76-49a4-a7ff-5, Tilburg University, School of Economics and Management.
    6. Panageas, Stavros, 2010. "Bailouts, the incentive to manage risk, and financial crises," Journal of Financial Economics, Elsevier, vol. 95(3), pages 296-311, March.
    7. Stavros Panageas, 2007. "Optimal Retirement Benefit Guarantees," 2007 Meeting Papers 172, Society for Economic Dynamics.
    8. Bossi, Luca, 2008. "Intergenerational risk shifting through social security and bailout politics," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2240-2268, July.
    9. Lee Redding, 2006. "Social Security Reform and Corporate Governance," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 9(3), pages 235-246.
    10. Stavros Panageas, 2010. "Optimal retirement benefit guarantees," NBER Working Papers 15805, National Bureau of Economic Research, Inc.
    11. George M. Constantinides, 2002. "Rational Asset Prices," NBER Working Papers 8826, National Bureau of Economic Research, Inc.
    12. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.

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    JEL classification:

    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment

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