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

49 Pages Posted: 18 Apr 2002 Last revised: 20 Jun 2002

See all articles by George M. Constantinides

George M. Constantinides

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

John B. Donaldson

Columbia Business School - Finance and Economics

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics; National Bureau of Economic Research (NBER)

Date Written: April 2002

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

Constantinides, George M. and Donaldson, John B. and Mehra, Rajnish, Junior Must Pay: Pricing the Implicit Put in Privatizing Social Security (April 2002). NBER Working Paper No. w8906. Available at SSRN: https://ssrn.com/abstract=307876

George M. Constantinides (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7258 (Phone)
773-752-0458 (Fax)

National Bureau of Economic Research (NBER)

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John B. Donaldson

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics ( email )

Tempe, AZ 85287-3806
United States
480 965 6335 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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