Is Social Security a “Ponzi Scheme”?

2011-09-09 § Leave a comment

I see many stories in the news making the claim that Social Security is a Ponzi scheme, or reporting on politicians who make this claim.

It’s clear from the comments that many people agree with Perry’s negative outlook. But what are the hallmarks of a Ponzi scheme, and in what way is Social Security similar?

Hallmark 1: the expected profit is markedly higher than other investments, so it is attractive to investors and makes them want to keep their money parked in the scheme or even add to their “investment”
Hallmark 2: new money pays the gains on previous “investments” to convince early investors that the scheme works
Hallmark 3: some mechanism is touted as generating a profit, sufficient to pay the promised return with low or zero risk
Hallmark 4: managers claim paper profits, but there is no actual income, or not enough to support stated returns. Therefore the scheme must fail sooner or later. It cannot continue indefinitely.
Hallmark 5: managers take funds for their own use
Hallmark 6: managers have no intention to pay obligations, except as needed to maintain the fiction

The first two are the essential elements. These are what convince people to join. The other main feature of a Ponzi scheme is that it is fraudulent, detailed in hallmarks 4 through 6. Hallmark 3 is just a story, part of the con, but isn’t strictly necessary. Mostly what is needed is a lot of gullible investors with money to lose.

So how does the Social Security system stack up? Let’s pose some questions.

Question: Is it an investment? Or does it look like an investment, as mentioned in Hallmarks 1 and 2? No. It is not an investment at all, and isn’t claimed to be. For the individual, it appears much more like a defined-benefit pension fund. Those who participate do not choose it, so there is no need for a high stated “rate of return” to keep you invested, nor is there even any way to “withdraw” your principal. To the extent that there is a principal, it isn’t yours. It belongs to the system. If you and your immediate family die, your estate gets nothing.

Question: Is it fraudulent? The two main answers are no, and no. Are the books cooked? No, in fact you can see for yourself what was done with the money. Do the managers extract money from the system and use it for unrelated purposes, without reporting the activity to participants and regulators? No. In fact Social Security has extremely low management overhead, compared to such things as mutual funds and annuities.

Question: Is the system doomed to fail at some point? No, it is not doomed. There is every reason to believe that obligations will be paid fully, both next year and a decade from now, even if no action is taken. With small modifications, there is no reason it won’t continue indefinitely, as long as no lasting financial catastrophes befall the American economy. (This would require a REAL calamity — such as a war that kills half our current workers and leaves existing retirees drawing benefits. The global financial crisis of 2008, while painful, is nowhere near the scale of crisis that could affect the viability of the Social Security system.) It certainly will not implode in the next 20 years, unless it is made to do so through purposeful legislative action.

So why the hullaballoo? Well, there are two ways in which it DOES resemble a Ponzi scheme.

First, current payments support current benefits, similar to Hallmark 2. Social Security is largely a “pay as you go” mechanism, with current payroll taxes used to pay benefits to past workers. If there were fraud involved, this is the part that would fool people into believing that the system works. But there is no fraud. We don’t just pay money to retirees who are suspicious about the safety of the money, we pay EVERYBODY who is entitled to benefits. We have always done so, every month for over half a century.

Second, similar to Hallmark 3, we hear about a “Trust Fund” stuffed full of safe investments whose promised return will help fund future benefits. This is really what has people worried, and gives grist to the mill of politicians who call the Social Security system’s viability into question. So it is important to understand it. Given what’s said above, it’s clear that Social Security is NOT a Ponzi scheme. But is it possible that there is some sleight of hand going on with the Trust Fund? Let’s find out.

The Trust Fund is the name given to all the money collected that has not been used to pay benefits and overhead expenses. It’s a lot of money — $2.6 trillion as of 2010 — and it’s what’s expected to make the Social Security system solvent for the next couple of decades as retirees live longer and the payroll tax base shrinks. It grew rapidly between 2000-2008, but will start shrinking soon. That means that, instead of having excess every year to put into the Fund, we’ll have to start taking money out. Where is the money, and how will it be retrieved to pay retirement benefits?

The answer is simple: it’s all in Treasury bills. Unlike, say, Norway, which invests its state pension fund surplus back into its own economy, the United States long ago chose to spend the surplus and pay it back later, with interest, from general tax revenue. This is not new. It first came to the attention of many people in the early 1980’s when  the fund became sizable (it rose above $100 billion for the first time in 1988). Even then, paying back $100 billion or so over the course of several years in some distant future seemed doable. Now, it doesn’t seem so easy. Where are we going to come up with $2.6 trillion over the next 20 years? That’s a lot of money, and in an economy like today’s, it will mean real pain.

If you were around in 1990, you heard a lot about “raiding the Trust Fund.” There was a lot of press, and recriminations all around. No significant changes were made, because then as now, our politicians could not keep their hands off such a large, sweet pot of money. Still, the answers to all the pertinent questions are simple, even if they are unpleasant:
Question: If the money is already spent, doesn’t that mean it IS all a Ponzi scheme after all? A massive fraud? No, it still isn’t. It wasn’t spent fraudulently or in secret. We all knew it was happening, even if we (and especially our elected representatives) preferred to pretend otherwise.
Question: If the money wasn’t invested in anything, doesn’t that mean the coffers are empty? No. Well, no more than they’ve ever been since the US has been in debt in a sizable way (which it has been since before 1940). The coffers are full of paper that is backed by the “full faith and credit” of the United States. That’s just another way of saying that future taxpayers will be forced to supply the money, like they will on the rest of the public debt, unless the US defaults.

It’s clear we will have to use government revenue from sources beyond payroll taxes in order to meet Social Security obligations in the near future — this is the taxpayer footing the bill for bonds that have already been issued, the same as all other government bonds. The only reason this might not occur is if Congress continues deficit spending AND they choose not to raise the debt limit. This has never happened, and need never happen, though it has been threatened.

If Congress does nothing to change the system, within about 20 years the supply of T-bills in the Trust Fund will be gone. At that point, the system MUST be changed, either with higher payroll taxes or reduced benefits or both. Even then, it will not fail in a way that resembles a Ponzi scheme. The system won’t be suddenly revealed to be empty and nonfunctional. It will just have to be adjusted, with a later retirement age and a higher payroll tax rate, perhaps 8% instead of 6%. If we make reasonable adjustments over the next 10 years, it need not seem like a crisis to anyone.

On the other hand, if Congress decides to dismantle the system and refuse to pay benefits, it will seem very much like a Ponzi scheme to those who paid payroll taxes throughout their working lives. This would require the proverbial act of Congress to achieve, though — a much more drastic action than just deciding to go the other way and fix the system.

The upshot, then, is that Social Security is a Ponzi scheme exactly to the extent that the US treasury is a Ponzi scheme. Anyone who claims it is, questions the faith and credit of the US government. Let us hope no one with that mindset gets into Congress or the White House.

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