Wednesday, May 13, 2009

New paper: “Measuring Social Security's True Liability”

The National Center for Policy Analysis released a new paper by Boston College economist Larry Kotlikoff titled "Measuring Social Security's True Liability." Kotlikoff's key insight is to apply market valuation techniques to Social Security's finances:

Every year the Social Security Trustees publish a report on the fiscal solvency of the program.  It details the program's unfunded liabilities, which is what the government will still owe after it uses current and future tax receipts to pay for current and future retiree benefits. In 2005, the Social Security Trustees estimated that the program's unfunded liabilities were $8.5 trillion.  This means that even after accounting for payroll tax revenues the federal government would have to have this much money in the bank today, accruing interest, in order to pay promises to future retirees.

However, the Trustees appear to be underestimating the value of Social Security's unfunded liabilities
because they are failing to take into account the riskiness of tax payments that have not yet been received and of benefits that have not yet been accrued
and the certainty of those benefits that have been established.  In effect, the Trustees are understating the
market value of Social Security's net liabilities - what the government would have to pay a private party or investor
to take the obligation off its hands.  As I showed in a recent paper with Alex Blocker and Steve Ross, to mark to market Social Security one needs to treat future government payments (Social Security benefits) and receipts (payroll taxes) as nontradable financial assets. 

Kotlikoff concludes that the market value of the Social Security shortfall – i.e., the amount the government would have to pay to get the private sector to assume Social Security's liabilities – is around 23 percent higher than the stated value reported in the annual Trustees Report. Click here to read the whole paper.

It's worth noting that the market valuation of Social Security financing is a developing field. Some economists, such as John Geanakoplos and Steve Zeldes, argue that on a market basis Social Security's shortfalls are smaller than reported. This is valuable work and hopefully the two sides will work toward common views.

No comments: