Vol. 5 No. 2 | Fall 2003

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Junior Must Pay

Privatizing Social Security-Costs vs. Benefits


Research by George M. Constantinides and Rajnish Mehra

As the baby boomer generation nears retirement age, fixing the U.S. Social Security system becomes an even more pressing issue. New research finds that privatizing Social Security is a risk worth taking.

One facet of the larger debate on Social Security reform has been the proposal to invest a modest portion of the Social Security Trust Fund in the stock market. The especially high stock market returns of the late 1990s ignited the privatization debate, which has since cooled (along with the stock market). Existing laws restrict investment of the Social Security Trust Fund to United States Treasury securities.

Social Security currently operates as a "pay-as-you-go" system where today's working generation pays taxes that provide income for the retiring generation. Researchers estimate that annual benefits mandated to the elderly will exceed the annual tax income by 2018 and the fund will likely be bankrupt by 2042.

Unlike capital market investments, Social Security is a form of social insurance, and is implicitly designed to guarantee a minimum benefit level for its participants. Given the volatility of the U.S. stock market over the past 70 years, however, there is the distinct possibility that Social Security funds invested in the stock market may decline in value and be inadequate to provide a basic level of retirement benefits. In such a situation, the government may be compelled to remedy the shortfall by raising taxes on the younger generations, essentially requiring existing taxpayers to be, by default, the underwriters of the retirement costs of the older generation.

A new study entitled "Junior Must Pay: Pricing the Implicit Put in Privatizing Social Security" by George M. Constantinides, a professor at the University of Chicago Graduate School of Business, Rajnish Mehra of the University of California, Santa Barbara, and a visiting professor at the University of Chicago Graduate School of Business, and John B. Donaldson of Columbia University investigates how much it would cost the younger generation, in higher taxes, should the stock market not deliver as expected.

"Our study looks at implicit promises to future generations," says Constantinides. "The price of these promises can be viewed as a 'put' option. We calculate the price of this put option as a fraction of one year's gross domestic product and find that it is small under a wide range of scenarios."

In the stock market, a put option functions as insurance against falling stock prices. In this case, the implicit put would be a taxpayer's guarantee that even if the stock market crashes, the retiring generation will still receive their Social Security benefits.

When 20 percent of Social Security Trust Fund assets are invested in equities, the highest level currently under serious discussion, the authors find that a put guaranteeing the currently mandated level of benefits is priced at 1 percent of GDP. This corresponds to a temporary increase in Social Security taxation of at most 20 percent. A put that guarantees only 90 percent of the currently mandated benefits is priced at roughly .03 percent of GDP, which is proportionately much less.

"Even considering the possibility of an economic catastrophe bigger than anything we have observed over the last one hundred years, the put option is actually tiny," says Constantinides. "In our calculations, we find that fears about privatizing the system are not justified, and should not prevent policymakers from moving ahead with Social Security reform."

The Equity Premium

Empirical research documents that stocks have historically yielded, on average, 6 percent higher returns than bonds, a differential referred to as the "equity premium." A central issue in the debate on privatizing Social Security is whether to invest the taxpayers' funds in stocks or bonds. However, as the authors point out, previous studies on Social Security do not employ models that explicitly examine how investing Social Security funds in the stock market will impact the equity premium.

Constantinides, Mehra, and Donaldson discuss the potential costs and benefits of privatization in the context of a model that accurately replicates the historically higher returns on stocks versus bonds. The authors also take into account the changes in the distribution of stock market returns after the Social Security Trust Fund is invested in the market.

Simply put, privatization will cause stock prices to rise as significant sums of money are invested in the market; thus the welfare consequences may be broader than simply raising Social Security Trust Fund returns.

"If the government were to invest even relatively small sums of money in the stock market, the equity premium would actually shrink, reducing the differential between stock returns and bond yields," says Mehra.

The authors examine these issues in the context of an overlapping generations life-cycle model, where each household has three stages. In stage one, the borrowing-constrained young are earning but not saving. In stage two, the wage-earning middle-aged are starting to become savers. In stage three, the old are no longer earning wages and must rely on retirement income, including Social Security. In the model, upon entering middle age, a young taxpayer achieves either high-wage or low-wage status, which is maintained through retirement. For some of the retired population, Social Security payments may be their only source of income.

If a large fraction of Social Security taxes were invested in the stock market, there would be differing welfare implications for different generations. Instituting such policies would increase security prices and reduce returns.

Reducing Income Inequality

The authors find that the groups notably affected by privatizing Social Security would be the high-income middle-aged and high-income seniors. If the Social Security Trust Fund invests either in equities or bonds, as opposed to the current pay-as-you-go system, such investing would substantially increase security prices, and the share of dividends belonging to the wealthier taxpayers would shrink.

Under a privatized Social Security system, the high-income middle-aged group would sacrifice more of their Social Security income to acquire a smaller proportion of these securities, and would receive less old-age income as a result. On average, the study finds that the income of wealthy taxpayers would be reduced in both middle and old age.

For the low-income middle-aged, however, the situation is very different. This group's age-based income profile indicates that as they age, income generally decreases. In addition, this group is traditionally underinvested in the stock market compared to their higher income peers. For this group, privatizing the Social Security Trust Fund represents substantial consumption smoothing, and their financial well-being would consequently improve.

One popular justification offered for privatization is that it will reduce old-age income inequality by enabling lower-income taxpayers to have stock market investments undertaken on their behalf.

If Social Security is privatized, wealthy middle-aged investors would be partially crowded out-acquiring fewer securities as well as paying more for them.

For the low-income middle-aged, the higher returns afforded by stock market investing increases their expected income and consumption when they reach retirement, without diminishing their middle-aged consumption level. Old-age income inequality would be reduced, and thus privatization would provide a smoothing of consumption across age groups.

Social Security already redistributes wealth between rich and poor, but privatizing a portion of these funds would further promote risk sharing, allowing people who are currently left out of the stock market to participate and reap the potential rewards.

The marginal upside benefit to a low-income middle-aged taxpayer is much greater than the loss to a high-income taxpayer. The authors find that adding the put will improve the future financial health of low-income taxpayers overall. Measuring welfare as the expected utility of a young consumer looking forward, the percentage welfare increase when the put is introduced is approximately 3.4 percent.

Furthermore, the authors calculated the welfare benefits for those born into the proposed system. Would a person born in this new environment be better off with privatized Social Security? The authors find that the answer is yes.

Instituting such privatization policies is seen to substantially reduce income inequality across the older generation. "This may ultimately be the greatest argument in favor of a privatized Social Security system," says Mehra.

A Historical Perspective

The Social Security system requires a long-term perspective to be understandable, and the debate about Social Security reform typically gets sidetracked by more pressing short-term issues.

"Social Security is a huge problem, but politicians know that the electorate does not much care about a time-bomb that may explode in 30 years," says Constantinides.

The authors suggest that the debate about privatizing Social Security should be revitalized.

Despite the benefits of privatizing Social Security, Mehra cautions that any potential stock market gain does not mean the government should cut Social Security taxes for the working generations. Cutting taxes as part of the privatization plan would actually be a road to disaster.

Instead Mehra advises policymakers, "Keep taxes the same and invest some of that money in the stock market; that is a fairly safe proposal that will make everybody better off."

The authors' conclusions indicate that fears about privatizing Social Security are unfounded. In addition, the authors return to the basic principles of finance-maintaining a balanced portfolio.

"We always preach that investors should diversify their portfolio with both stocks and bonds," says Constantinides. "Social Security is no different."

 

George M. Constantinides is Leo Melamed Professor of Finance at the University of Chicago Graduate School of Business. Rajnish Mehra is visiting professor of finance at the University of Chicago Graduate School of Business and professor of finance at the University of California, Santa Barbara.

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