Market Innovations to Better Allocate Generational Risk

Mandatory programs for old-age benefits tend to require periodic adjustments due to demographic and economic uncertainty. Relying on discretionary legislation for these Social Security adjustments creates political risk for workers and beneficiaries, and it can also raise risks borne by taxpayers. An alternative approach is rule-based adjustment, as in the case of funded mutual funds and life insurance plans that offer annuities. This paper argues that rule-based adjustments can be adopted in an unfunded system, without incurring transition costs and without increasing the public debt. We evaluate an approach to this problem which would endow the Trust Fund with property rights over the revenue of a (much reduced) residual payroll tax paid by future workers. Revenue on the future taxes would be securitized and the resulting securities priced in financial markets. The new securities created in the process would allow beneficiaries to obtain safe real pensions protected from investment risk.