Social Security safety net with rare event risk

Abstract

The US Social Security program was created in part as an explicit response to the Great Depression. We evaluate the performance of Social Security as a protective safety net against a rare episode of sudden and significant loss of private wealth such as the Great Depression. We construct a model in which a rare event causes a shock to wealth at an unknown time. How well does Social Security function as a safety net against such risk? The answer depends critically on whether households optimize in the face of this risk. If the household has full information on the distribution of rare event risk and solves a dynamic stochastic problem to hedge this risk, then Social Security is unnecessary along this dimension. Alternatively, if the household does not account for rare event risk in its financial planning, then Social Security can provide very large welfare gains as a safety net.