The Effect of Pay-When-Needed Benefit Guarantees on the Impact of Social Security Privatization

Kent Smetters

in Risk Aspects of Investment-Based Social Security Reform

Published by University of Chicago Press

Published in print December 2000 | ISBN: 9780226092553
Published online February 2013 | e-ISBN: 9780226092560 | DOI:
The Effect of Pay-When-Needed Benefit Guarantees on the Impact of Social Security Privatization

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This chapter adopts a different perspective on government minimum-benefit guarantees in investment-based social security systems. It argues that market prices should be used to evaluate the costs of such guarantees. The guarantees are equivalent to put options — social security participants are effectively granted options to put, or sell, their investments to the government at minimum prices — and option pricing theory can therefore be used to value them. Using this approach, the chapter finds significant costs even for guarantees that are extremely unlikely to be activated. The chapter also argues that increasing the rate of contributions for personal retirement accounts (PRAs) is an inefficient way to address the problem because it increases benefits in a variety of different situations. It proposes instead that higher PRA contributions should be used in effect to buy put options on behalf of social security participants. After discussing the risk in stocks over long periods, the chapter looks at how minimum-benefit guarantees are evaluated in the context of social security. It also outlines the model used and the stylized privatization reform.

Keywords: minimum-benefit guarantees; social security; privatization; personal retirement accounts; market prices; put options; investments; stocks

Chapter.  9151 words. 

Subjects: Economic Systems

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