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
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
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
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
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
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
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
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
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.