The Effect of Pillar 1 on Efficient Investment Portfolio Choice in the Case of the United States

Pillar 1 of the U.S. retirement system is the Social Security system. It is both the largest social insurance system in the world and an important instrument of public policy. It provides universal retirement benefits based on wage history, and the number of years of service (up to 35 years). It is a core source of retirement income for American workers. In this paper, we consider this system as a part of capital markets, by asking how a person’s optimal investment portfolio is affected by the existence of the Social Security System. We do this by calculating the optimal portfolio allocation at various levels of risk (i.e. the efficient frontier) for portfolios including a proxy for Social Security. This perspective is new in comparison to the existing literature on the subject. We show that the composition of the efficient frontier suggests arbitrage opportunities between Social Security and private capital markets, especially when portfolios optimal from the point of view of real returns are considered. We also note that exploitation of those opportunities may have important policy implications, as it may lead individual investors to treat Social Security as the “safe anchor” of their portfolio, and then taking more risk and assuming more leverage, in a potentially unsustainable fashion, in their remaining asset allocation.