What discount rate should the government use to measure the financial status of various government programs and the impact of potential policy changes? How, if at all, should the discount rate take into account the risk of the underlying cash flows? We examine these questions in the context of one of the largest components of the U.S. budget: Social Security. Official measures of the U.S. Social Security system's present value funding shortfall are computed using the risk-free interest rate. Yet future Social Security expenses and revenues are, by law, linked directly to future realizations of the aggregate wage. We build a model in which consumption and wages are cointegrated and recompute common measures of Social Security's funding status using the modelimplied risk adjustment. We find that the risk-adjusted shortfall in Social Security is between 18 and 68% less (depending on the measure) than indicated by the official statistics.
We also examine three policy changes that have been proposed to bring the system back into balance: increasing payroll taxes, decreasing benefits, and indexing benefits to prices rather than wages. For the first, we find that even though adjusting for risk reduces the present value shortfall, it actually increases the tax rate increase necessary to bring the system back into balance. For the second proposal, risk adjustment has ambiguous effects on the magnitude of benefit cuts. For the third proposal we find, contrary to the results of models that ignore risk, that linking benefits to prices instead of wages would increase the cost of Social Security benefits and thus increase the shortfall.