Social Security and the Equity Premium Puzzle

Abstract

This paper shows that social security may be an important factor in explaining the equity premium puzzle. In the absence of shortselling constraints, the young shortsell bonds to the middle-aged and buy equity. Social security reduces the bond demand of the middle-aged, thereby restricting the possibilities of the young to finance their equity purchases. They demand less equity and the return to equity goes up. Social security also increases the covariance between future consumption and the equity income of the young. The efect on the equity premium is substantial. In fact, a model with social security and borrowing constraints can generate a fairly realistic equity premium.Asset prices; the equity premium puzzle; social security