Implications of Social Security Reform on Interest Rates: Theory and Evidence

20 Pages Posted: 2 Dec 2002

See all articles by Erick M. Elder

Erick M. Elder

University of Arkansas at Little Rock - College of Business Administration

Larry C. Holland

University of Arkansas at Little Rock - College of Business Administration

Abstract

This article investigates the potential effect that Social Security reform may have on bond and equity returns. We specifically focus on the effect of proposals to shift a portion of the investment of the U.S. Social Security Trust Fund to the equities market. Models are developed to demonstrate the relationship between returns and both the relative size of the Social Security Trust Fund and the portfolio allocation of the Trust Fund. Using these two models, we then show that interest rates will increase from either a decrease in the size of the Social Security Trust Fund or a shifting in the investment mix from bonds to equities. We derive an adjustment factor that relates the magnitude of change in interest rates from either source and use this adjustment factor in conjunction with estimates of the relationship between government debt and interest rates to forecast the potential effect on interest rates from shifting part of the Trust Fund to the equity market. The estimates herein suggest that investing some of the Social Security funds in equities is not a painless cure-all for the Social Security system and may even have some adverse effects in terms of income transfers from American taxpayers to foreign bondholders.

Suggested Citation

Elder, Erick M. and Holland, Larry C., Implications of Social Security Reform on Interest Rates: Theory and Evidence. Journal of Risk & Insurance, Vol. 69, No. 2, pp. 225-244, 2002. Available at SSRN: https://ssrn.com/abstract=314358

Erick M. Elder (Contact Author)

University of Arkansas at Little Rock - College of Business Administration ( email )

Little Rock, AK 72201
United States

Larry C. Holland

University of Arkansas at Little Rock - College of Business Administration ( email )

Little Rock, AR 72204-1099
United States
501-569-3042 (Phone)
501-569-8871 (Fax)

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