New paper: “The True Cost of Social Security”

A new paper by Alexander W. Blocker (Boston University), Laurence J. Kotlikoff (Boston University) and Stephen A. Ross (Massachusetts Institute of Technology) attempts to assign a market value to Social Security's long-term unfunded obligations. "The True Cost of Social Security" treats the Social Security program as a financial asset with certain unique characteristics, and then uses modern finance theory to place a value on the promises made under that program. Here's the summary:

Implicit government obligations represent the lion's share of government liabilities in the U.S. and many other countries. Yet these liabilities are rarely measured, let alone properly adjusted for their risk. This paper shows, by example, how modern asset pricing can be used to value implicit fiscal debts taking into account their risk properties. The example is the U.S. Social Security System's net liability to working-age Americans. Marking this debt to market makes a big difference; its market value is 23 percent larger than the Social Security trustees' valuation method suggests.

In other words, the true value of the long-term Social Security shortfall could be significantly larger than we currently suppose.

I may have touched on this issue in discussion of the report of the 2007 Technical Panel on Assumptions and Methods. The panel's report, which came out several months ago, cited a paper by John Geanakoplos and Stephen Zeldes which attempted a similar exercise to the Blocker, Kotlikoff, Ross paper. However, Geanakoplos and Zeldes concluded that, using market pricing, Social Security's long term deficit was around 25 percent smaller than the Trustees project. In other words, both papers utilize more sophisticated analytical techniques but come to precisely opposite conclusions.

My issue with the Tech Panel's report was that it recommended adopting the Geanakplos-Zeldes approach in the Trustees Report:

The Panel recommends that the Trustees consider adopting risk-adjusted discount rates for computations that involve discounting. As well as making the measures more accurate theoretically, the use of higher discount weights has the salutary effect of reducing the sensitivity of the results to the more distant, and more uncertain, cash flows.

This, I thought, was premature given that the Geanakplos-Zeldes paper hadn't even yet been published, and the Blocker, Kotlikoff, Ross paper makes me think even more that these methods aren't quite ready for prime time. The Trustees Report currently contains some new approaches that it didn't use 10 or so years ago – stochastic forecasting, the infinite horizon actuarial balance, and others – but these methods were thoroughly used in academic and policy research before being applied in the Trustees Report. I suspect that market pricing of Social Security liabilities should go through a similar process before going in the Trustees Report.