By the time today’s youngest generation of workers retires, Social Security will likely face a deficit in the trillions of dollars. Most experts agree that the system needs an overhaul. But first, policymakers need a way to measure the extent of the shortfall.
The Social Security Administration (SSA) measures the financial health of the system by estimating future cash flows (benefit payments and worker and employer contributions) and discounting them into today’s dollars, to arrive at a measure of present value. But what discount rate should be used? The government currently uses a rate that makes no adjustment for risk: the yield on riskless Treasury bonds. But Social Security cash flows are not riskless, says professor Stephen Zeldes. Ignoring that risk leads the SSA to use too low a discount rate, producing an inaccurate measure of Social Security’s present value — and of its long-run health.
Social Security benefits are wage-indexed: payments are based on an individual’s earnings history and the average national wage in the year that the individual turns 60 years old. Those who have the good fortune of turning 60 in a year in which wages are high will have higher benefits. In subsequent years, benefits are adjusted for inflation, but not for wage growth. Because the average wage fluctuates over time, any valuation of future benefits should account for this risk, Zeldes argues.
Zeldes and John Geanakoplos of Yale University have proposed a way to account for market and wage risks. They first ask, if cash flows were traded as securities on financial markets, what would their market prices be? To determine this, they first propose creating a wage bond, a security tied to the average national wage that when it matures would pay an amount equal to the average national wage that year. They use asset pricing methodology to determine what the discount rate and market value of these bonds would be. Since Social Security cash flows are closely related to those of wage bonds, the prices of the wage bonds can be used to compute the market value of Social Security cash flows.
Pricing wage bonds is not an easy exercise. Research has shown a positive long-term correlation between average wages and stocks. “This means that distant payoffs on wage bonds will tend to be low if the stock market has performed poorly and high if the market has done well,” Zeldes says. To price wage bonds, Zeldes and Geanakoplos developed a model that links wages, dividends and stock prices. The model accounts for specific behaviors of the economy and markets, and also draws on common techniques used to price derivatives. Using this model, the researchers came up with an appropriate discount rate for valuing future cash flows.
“It’s fine to use close to a risk-free bond rate to discount Social Security benefits that will be received in a couple of years, because the short-run riskiness of wages is low,” Zeldes says. “But for benefits in the distant future, the discount rate should be much higher than the one now used by the SSA. Our model shows that the rate should be much closer to the rate that would be applied to stocks.”
The researchers apply their methodology to estimate the maximum transition cost. This equals the present value of all benefits that have been accrued to date, minus the current value of the Social Security trust fund. In other words, the maximum transition cost indicates how much extra money the trust fund would need, if the Social Security system were shut down today, in order to ensure payment of all benefits already accrued as a result of past earnings. Applying the SSA methodology that ignores risk yields an estimated gap of about $11.1 trillion. “But we find that the risk-adjusted market value of this gap is about 23 percent smaller than this, i.e., only about $8.6 trillion,” Zeldes says. “This means that the cost in today’s dollars of paying future benefits is not as high as most people perceive it to be.”
In ongoing work, Zeldes and Geanakoplos are examining other measures of Social Security financing gaps, including ones that take into account future tax contributions. In addition to changing the way the system is measured, Zeldes and Geanakoplos would like to transform the system itself, and to that end have proposed a system called Progressive Personal Accounts. “Our plan incorporates market mechanisms into Social Security yet also maintains and even improves on the protection and safety provided by the current system,” Zeldes says. “Social Security is generally well designed, but there are some fundamental changes that could make it even better.”
Stephen P. Zeldes is the Benjamin Rosen Professor of Finance and Economics and academic director of Columbia CaseWorks at Columbia Business School.