The Risk Premium for Equity: impKcations for tlie Proposed Diversification of the Sooiai Security Fund

The United States Social Security system has accumulated unfunded liabilides esdmated at $9 trillion (John Geanakoplos et al., 1998). The need to meet these liabilides implies, other things being equal, a need for higher taxes in the future. The need for transidonal policies to fund the accumulated liability has generated increased interest in proposals for policy change which may yield improvements in efficiency and, in pardcular, improvements in the retum to Social Security investments. A number of proposals addressing the unfunded liabilides involve dropping the requirement that the assets of die Social Security fund should be invested solely in bonds and allowing some of the assets of the fund to be invested in equity. Cridcs such as Alan Greenspan (1999) have observed potendal confiicts of interest associated with public ownership of equity. A more fundamental cridcism has been the observadon that, in the absence of capitalmarket inqierfecdons or restricdons on the capacity of individuals to diversify risk, the diversificadon of Social Security investments into stocks will be offset by reallocadon of individual asset portfolios. More precisely, as Geanakoplos et al. (1998) show, under die assumpdons of optimizadon, time hotnogendty, stable prices, and spanning, the diversificadon of Social Security investments into stocks has no effect on measures of the "money's worth" of Social Security. This result holds whether