The Welfare Cost of Perceived Policy Uncertainty: Evidence from Social Security

Our main results indicate that individuals perceive the risk to which policy uncertainty exposes them and that the welfare cost of that risk is statistically and economically significant. Across respondents, the average expected benefits are 59.4 percent of the benefits the respondents are supposed to get under current law. The average certainty equivalent is 53.7 percent, yielding an average risk premium of 5.8 percent. At 7.0 percent, the median risk premium is close to the average risk premium. These risk premia are expressed as percentage of benefits under current law, but would become 9.7 percent and 11.8 percent, respectively, if expressed as a percentage of expected benefits.

Our results show that the risk premium is higher when people are more dependent on Social Security or have less time to mitigate uncertainty in Social Security by changing their labor supply or savings rate. For example, older people and those with lower incomes have higher risk premia. Given the large role that Social Security plays in retirement, our research suggests that a considerable welfare gain is possible by finding ways to reduce uncertainty about its eventual reform. Some possibilities include acting sooner rather than later, or legislating rules in which benefits automatically adjust to macroeconomic and demographic changes to keep Social Security solvent.

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