Are We Financially a “Lost Generation”?

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My friend Glen Craig from Free From Broke shared an interesting article on Facebook last night. With a comment of "wow", and former Lending Club friend Rob Garcia chiming in with "whoa", it got my attention. The article The typical American family makes less than it did in 1989 from The Washington Post has nearly 900 comments as I write this.

I read the article and shrugged. I must be missing something.

The article compares inflation-adjusted median household incomes between now and 1989. It even gives showing all the years in between. The author states:

In 1989, the median American household made $51,681 in current dollars (the 2012 number, again, was $51,017). That means that 24 years ago, a middle class American family was making more than the a (sic) middle class family was making one year ago.

This isn't a lost decade for economic gains for Americans. It is a lost generation.

Why should we expect to make gains on median household income on an inflation-adjusted basis? It's like getting on a treadmill and being upset that you walked for a half hour and went nowhere. I guess according to the author this is a lost half hour and yet millions and millions of people find value in it every day.

It seems quite an over-reaction to a loss of 1% of income... or about half a percent after taxes.

The Value of Living Today

Glen on Facebook brought up and interesting point, "After reading the article I also wondered what the cost of living is compared to back then. What if we just don't need as much money for some things as we did back then, like computers?"

My family was one of the earlier families on the block to get a personal computer (The awesome PCjr) back around 1985. Even as we upgraded to 286, 386, and 486 computational behemoths, we never had more than one computer. Today we have numerous laptops, mp3 players, and tablets. The $2000 that my family spent on a computer back then is pretty similar to the $2000 that we spend on various similar technologies today.

We can look back at what my family paid for a landline. I think it was around $40 a month and there were extra charges if you wanted to call long-distance. Today we have Ooma Telo free home phone service, but it piggybacks on a cable bill that has grown from around $20 a month to $125 a month. In addition, many people spend another $100-$110 a month on cell phones and service.

The price of cars have gone up over that time. However, when you adjust for inflation they are pretty much the same (at least through 2006 in that chart). The price hasn't changed, but you get many more safety features, better gas mileage, increased technology, and comfort.

Lost Generation? Really?

Are we really saving money on computers nowadays? Probably not. Are we really saving money on cars? Nope. However, in both cases our money gets us exponentially more than it did back 1989.

The mere fact that an ordinary person with no journalism degree like me can write to thousands of readers and convey this article is noteworthy.

Does that sound like a "lost generation" to you? Me neither.

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Posted on September 18, 2013.

4 Ways the Global Economy Affects the U.S.

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[Editor's Note: The following is a post by Annie Davis. She is a freelance writer from Tampa FL who enjoys writing and sharing her financial tips and knowledge.]

If you don't read global news and financial topics, you might not realize to what extent the global economy affects the U.S. economy. The truth is that every country in the world has an effect on the economy in every other country. Understanding how and where that happens may change your mind about the way you spend and the things you buy.

Importing Items Sees a Huge Impact

The U.S. gets many goods through importing. The country imports certain foods, fruits, and vegetables that only grow in other, exotic areas, along with all sorts of gadgets such as televisions, smartphones, computers, Blu-ray players, and similar items, because while the goods and materials are here, another country may have more knowledge or a quicker factory or workforce. If the price of the items frequently imported into the U.S. goes up or down because of the global economy or individual economies in Japan or Italy, it affects the American economy as well.

Global Economy Affects Exporting

The U.S. also exports many goods to other countries all around the world. Large items such as cars and trucks, airplanes, and computers are big exporters, because they're very much needed in other parts of the world. The state of the global economy affects how much money the United States receive for these goods and services, however. When the overall economy is low, the U.S. won't pull in much money for the items it exports.

Business Loans Aren't as Easy to Come By

If you're thinking about starting up a small business, you need to know what's going on with the global economy. Even though you feel far removed from the rest of the world, it impacts what happens in America. Specifically, there are certain bank regulations coming into play that may well affect your ability to get a loan to start your business.

Banks now have to protect their money, requiring them to assess the risk of lending money to any given business. What happens to your business in Chicago or Tampa could in theory affect the European Central Bank. When you're ready for a loan, it's a good idea to know your risk assessment and get firsthand knowledge from a quality source, such as John Ferraro of Ernst and Young, who can even help you do what you need to secure a loan.

Gas Can Crash the Economy

An image chosen by the guest author (seriously) by Jen Gallardo

Gas has one of the biggest effects on the economy in the United States. Drivers here rely on gas from overseas, and oil embargoes and controversies can cause a lot of problems here. You need only look at the current cost of gas to realize that. The New York Times estimates that the average driver in the U.S. pumps 60 gallons of gas every single month. With gas prices ready to increase at any given moment, you can see what the cost of importing fuel does to the U.S. economy.

The economy of the world creates a kind of butterfly effect—and so does the U.S. economy. How does that make you feel about your spending habits?

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Posted on August 26, 2013.

4 Best Ways to Survive a Tough Economy

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While I'm experiencing a second delay at the airport, I'll pass along this guest post from Anthony Alexander. He is a freelance writer who enjoys sharing his financial experiences with others. In these rough economic times Alexander feels it is important to share all the tips and advice possible to help others.

Tough times in the economy usually equate to tough times for individuals and families who are trying to get by on limited funds, a low level of job security, and a rising cost of living. There are some great strategies you can implement if you are trying to survive in this tricky situation and here are 5 tips to help:

Don’t Buy What You Can’t Afford

Expensive Property

You can't afford this, can you? via Jimmy Harris

It may sound like an incredibly obvious statement but 'don’t buy what you can’t afford' is actually one of the most important rules to stick to during financial uncertainty. We have all gotten used to being able to finance and borrow for items which are outside of our current means, but in the midst of a tough economy this is a very bad idea. Your credit card is not your friend and can land you in a lot of trouble if the card limit exceeds your monthly spare income level.

Only Buy if You Can Afford to Pay in Cash

It is all too tempting to take out a loan to pay for a new car or get a mortgage for a new property, but if the economy takes another downturn you could end up paying the bank back more than your house is actually worth. As a general rule, if you can’t afford to make a purchase with cash, it is likely that you cannot afford it full stop. If we have learnt one thing from the last recession it is that spending more than you are earning and hoping that you will be able to keep up with repayments is a really bad idea. Just because finance options may be available it doesn’t mean they are a good idea.

Get into a Long Term Mindset

If the current economic situation is improving month on month, do not assume that this is the end of hard times. Things can change quickly in today’s global economy so it is best to be prepared for change. What does this really mean? If you are currently earning more than you are spending, instead of splashing out on new things which you can do without, plan for the future and put aside as much as possible each month. A good portfolio will help to ensure that you have enough savings during harsh times. Using an investment company like Fisher Investments overview is a great way to start.

Creating a Budget to Keep Spending Under Control

Creating a sensible and realistic budget will ensure that you know exactly what money is coming in, what your overheads are, and what spare cash you may have each month. It is extremely important to stick to your budget and not to overspend as this is where problems begin to occur. It takes a lot of self discipline but if you can manage to overcome your spending urges you will be in a much stronger financial position. One of the most surprising things you will notice is how much you can save by making little changes such as taking lunch to work, getting rid of the extras on your mobile bill, and disconnecting your landline if you don’t use it regularly.

A tough economy makes life difficult for everyone but if you secure your own financial security by following the tips above you can ensure that you do not end up in a mountain of debt that you are unable to pay off. Sensible spending and saving is the key to your own financial stability and you are in control of this.

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Posted on July 16, 2013.

Thoughts on the Fiscal Cliff “Solution”

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Over the past six and a half years, I've written quite a bit about personal finance and related financial news. However, whenever the really big financial news comes out, I'm often not interested in writing about it. Such is the case with the fiscal cliff. It seems like every news outlet is either writing about that or what's going on Kim Kardashian's tummy and I can't recommend spending your time on either.

A few weeks ago, I relented and wrote about this fiscal cliff thing and I'm going to do today.

I have four main areas that I'd like to cover with regard to the fiscal cliff:

1. The 2% "payroll tax hike"

I've read numerous articles claiming that everyone's taxes are being raised. Each article points to the 2% tax relief we (Americans) got to help boost the economy. This came from the Social Security tax. In other words, we took more from an underfunded source creating a bigger problem in the future. Guest author Kosmo covered it well in this article, Social Security’s Death Clock Ticks Faster this Year:

"So we take a program that is already on shaky ground ... and cut funding? Sure, it will be great to have a few extra dollars in our pocket on pay day (I like extra money as much as the next person), but this seems to be missing the forest for the trees. Then there's the prospect of this cut ending at the conclusion of 2011. Will it really end? Or will there be fear that a reversion to the regular rate will be characterized as a 'tax increase'? If that's the case, we could see a few more years of underfunding for social security until someone finally has the cojones to say 'If we want to keep Social Security, we need to pay for it.'"

Nostradamus had nothing on Kosmo. Almost every article I read is characterizing this reversion to the regular rate as a tax increase. While technically true, it doesn't deserve the bad press surrounding it. Either be thankful you got it in the first place, or celebrate our Social Security funding getting back to the norm.

The upshot of the 2% means that someone making $30,000 is going to be making around $50 less a month. I realize that there are a lot of struggling people out there. I feel for those people. On the other hand, to the people with iPhones and iPads complaining about this, “I’m Like, ‘F@#% You!’”.

I can save most people a lot more than $50 a month, relatively painlessly. I put a bunch ideas on that here: fast finance fixes.

2. The raising of taxes on people making 250K vs. 450K

We just finished saying how it is such a crime that the people making $30,000 a year are going to lose $50 a month, right? With all the struggling people and the high unemployment rate, we should be focused on these people right? So what better way to demonstrate the highest level of hypocrisy by making a big deal out of whether we are raising on those making 250K, 450K, or 1M?

Let me make sure I'm clear on this: Congress was quarrelling over whether to raise taxes on the top ~98% or the top ~99% at the expense of everyone (including those in both ranges since they'd have their taxes raised too).

The only way this could make less sense is if the quarrel was irrelevant in the first place. And according to this Forbes article it was. The long shot is that many of these people are going to get hit by the Alternative Minimum Tax (AMT) anyway.

Awesome... all that fighting for what seems to be nothing.

3. This "Solution" is just a drop in the bucket

The taxes amounted to 61 billion in more income a year for the government on average, while the annual deficit is something like 1100 billion (or better known as 1.1 trillion). So we've fixed about 5% of the problem for this year... and then we've got another 16 trillion in debt behind that.

I like how Rob Berger of The Dough Roller put it in one of the comments of his article: "... we’ve spent an extraordinary amount of time arguing over taxes on the top 2 percent when the revenue they will generate is so small compared to our problems. It would be like focusing all of our attention on patching a small hole in the Titanic while ignoring a huge hole on the other side of the ship."

I wish I was an artist so I could draw some kind of political cartoon with an ant ($61 billion) trying to fight an elephant (1.1 trillion) and both them not being aware of the nuclear bomb being dropped on them (16 trillion). I realize you have to start somewhere, but it is ridiculous to be fighting a this level.

4. The people upset with politicians in Washington

This reminds me of one of my favorite Buffy the Vampire Quotes: "So, Dawn's in trouble... must be Tuesday." In other words, what else is new?

I am shocked that night after night the news was able to find people legitimately surprised by everything that happened with the fiscal cliff. I turned on CNBC and people were complaining about the lack of leadership in Washington.

How much progress do you think would be made if you put the Hatfields and the McCoys in the same room and told them they had to come to an agreement. What about the Autobots and the Decepticons? You get the idea.

It's like complaining that a country in the middle of a civil war isn't leading the rest of the world. It just isn't going to happen.

I'm trying hard not blame one political party or the other, but well, screw it. When someone says, "The rape guy lost the election" and another person has to clarify, "which rape guy?" your political party has a problem. When one of your most public faces, Michele Bachmann, doesn't know the basic facts about vaccines and autism, and publicly displays her ignorance many times, it demonstrates a lack of intelligence in your party's leadership. All is not lost for your political party though... in the past few months Chris Christie has shown multiple times that he's there for the people he represents with his response to Hurricane Sandy. He's not afraid to praise the other political party when they help the cause. He's not afraid to blast his own party and John Boehner when they leave without voting on the bill that would aid victims of Hurricane Sandy.

With people like that, maybe there's hope that common sense and coming together for the welfare of the nation can still happen.

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Posted on January 3, 2013.

What is this Fiscal Cliff Thing?

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I've got a bit of a confession to make and it may solidify my standing as one of worst personal finance bloggers ever. After the election results came through with Obama projecting to win Ohio, I saw a bunch of tweets on my Twitter stream with two messages: 1) "Congrats Obama" and 2) "Next up, tackle the fiscal cliff."

To the Google phone website: What is this fiscal cliff thing?

This Wikipedia article does a much better job explaining the fiscal cliff than I ever could. It's too complex to break down in this post, so I'll do a grand generalization and let you get all the fine details from there if you are interested.

The grand generalization is two-fold:

  1. Some tax cuts that President Bush created during his time in office are expiring
  2. Some planned budget cuts from the past would expire resulting in more spending

As I mentioned before it gets complicated especially with the politics of the Republicans and the Democrats slinging a bunch of nonsense. On my recent drive across the country, talk radio had Rush Limbaugh, Glenn Beck, and Sean Hannity on the multiple channels. I'm not into politics, but these big three of conservatives made it sound like Obama was out to purposely kill America, by raising taxes on the wealthy to help balance the deficit. Sounds like a very logical thing to me, but I've lived in blue states my whole life.

During the week, I ended up listening to a good 30 hours of their unproductive hatred of the democrats... stuff that makes a Red Sox fan and Yankees fan having a "discussion" after a few beers seem downright civilized. I finally came to this conclusion...

I don't care about the fiscal cliff... and neither should you.

Well, you should care about the fiscal cliff a bit, because it can have a real effect on your financial situation. If taxes go up, you'll have less money to spend. If spending is cut, you might lose on some key benefits you were counting on.

However, unless you happen to have the ear of the politicians working on it, you can't change anything that's going to happen with it. It's out of your hands. With that being the case, let's look at the things you can control:

  • Limit Your Tax Liability - If nothing is done long term capital gains tax will go up. So if you are sitting on a pile of stock and are looking to use the money any time soon (I love the real estate market), this may be a good time to sell some stock and hold on to cash. I'm personally not going to sell any stock, choosing instead to stay invested and hope that the gains of the market surpass the tax liability. This is also a good time to think about putting more money in a Roth IRA as you'll get it tax free no matter what the tax rate is. If income tax rates go up, there will be even more incentive to stash money in your company's 401k plan.
  • Minimize Your Expenses - Look into cutting down on any unnecessary subscriptions. I know multiple who have Netflix subscriptions that they admit they don't use. It may seem like a drop in the bucket, but it adds up to a couple of hundred dollars a year. I've compiled hundreds of ways to save money on nearly everything.
  • Double up on your Investment in your Career - Learning a new skill or two can not only help you keep your job, but also get a raise. Sure, some careers have limited ceilings, but you'd be surprised how many do not. I learned that lesson when I worked at Papa Gino's (a New England Italian food chain) at the age of 16. While being a cashier was my specialty (no one knew the PLU codes like me), I soon learned that if I could make pizzas and man the grill area, I'd be more valuable to them. I was one of the first to do dishes during the slow period, which showed management that I had the drive to do even mundane tasks if it helped the business (the truth was that I was just bored). In the end, it didn't take long before I was getting raises and as many hours as I wanted to work.

    Don't know what you can do to make yourself more valuable to your company? Ask your manager that question, she/he should be able to give you a good and hopefully productive answer.

If you going to waste your time with pointless debates, I suggest you move away the Republicans and Democrats debating the fiscal cliff and go all out and check out some Skip Bayless / Stephen A. Smith debates on the Patriots (ESPN is good for one of these annoying things a month):

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Posted on December 10, 2012.

Gas Going to $5 in 2012? Here’s How to Fight Back.

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Last week, I noticed many media outlets predicting $5 gas in 2012. It seems to have started from this post from GasBuddy. The theory goes that we have some of the highest gas prices we've ever had, and during the summer months prices typically get higher. This GasBuddy chart has the nation's average price at around $3.34 as of today. GasBuddy also says that prices typically peak at 93 cents from the start of the year. that would bring the average around the country to roughly $4.27, most likely in time for your Memorial Day vacation.

Where does the $5 come from? It seems that all the uneasiness and politics in the Middle East, particularly Iran, could lead to a slowed production of oil. That could raise prices. GasBuddy is even suggesting that oil prices could pass their high of $147 in 2008. While it seems that GasBuddy is the catalyst, CBS New York, CBS Baltimore, and ABC seem to be jumping on board with the possibility. Of course gas prices vary throughout the country, so if some places see $5 gas, others may avoid it.

So what can you about this? You can try to occupy your local gas station, but don't expect that to get gas prices lowered.

I see two things that you can do. The first is to look into these tips on saving money on gas. That's a no-brainer.

The second tactic is less obvious. If GasBuddy is right and the price of oil goes from around $100 today to the $150 record highs, you can make a lot of money by investing wisely. I have some money put aside in PowerShares DB Oil Fund (DBO). At that peak of oil price of $147 in July of 2008, the stock reached nearly $55 a share. It currently trades at around $30. If we see a similar trend, perhaps that stock jumps to between $50 and $60 a share. If so, you could nearly double your money.

As long as you invest enough, doubling your money would certainly ease the anxiety at the gas pump, right?

Who is up for a game of guess the peak gas price average (as reported by GasBuddy) this year? I'm going to go with $4.16. Leave your guess in the comments.

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Posted on January 12, 2012.

A Sucker Punch of Personal Finance to America

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In the last 24 hours I've had three experiences drastically change how I feel about personal finance in America - one of them major, one of them minor, and one... calling it a stretch would be generous.

Last night, my wife called me from her hotel in upstate NY. That's a long ways from our San Francisco home. She said, "It's worse that I thought here."

Let me back up a bit. My wife has a white-collar job in the military. She asked to be deployed to help with victims of Hurricane Irene as that was a requested need. I was surprised to hear about a military deployment to Hurricane Irene months after the fact. I didn't really take the need that seriously. It seemed that Vermont got all the news stories, not New York (though there's not a large distance there). I had figured that by this time everyone had reached safety. This clearly wasn't going to be like the deployment for Katrina that I've heard so many stories that I won't repeat in this space.

What's so bad in upstate, NY? It turns out it is a personal finance nightmare. There are people who don't have houses because they were swept away by the river. Some of these people didn't have flood insurance. (Dear FEMA, you require me to buy flood insurance when I already have it, and others don't have to have it at all? Really?!?!) Many people lost their jobs because they were literally washed down the river as well. My wife explained that these people are in the worst kind of pickle - no home so they can't get a job... no job, so they can't get a home. I've never really thought of this predicament. Two thoughts immediately came to mind:

  • Where's the emergency fund? It kills me that over and over again, people don't seem to have an emergency fund set up. They don't realize it until something that they can't control and devistates them - like a hurricane or a flood.
  • What about and extended stay hotel on credit cards? I know it's not a good situation, but getting income is key and if a place of residence is required, get an extended stay hotel and use that. You need to stay somewhere. In times like this, it's probably worth even looking to cash out some those Roth IRA and 401k savings. The kind of thing is a financial set back, but you are able to live.

I'm waiting to hear more details about the pickle, because it seems solvable especially in extreme cases that effects the whole community. I'll be waiting for a couple of weeks until my wife gets back. Then I'll be able to ask her in more detail.

I do believe she is coming away with a new appreciation of sound personal finance. Though in some ways she may think my site is more of joke now, as I don't cover these extreme situations - the ones where people need the most help. I honestly don't have a lot of experience with such situations, so I don't know if my advice would be helpful. I'm better off at handing the "problem" of having maxed out your 401k too early in the year (we should be so lucky).

There's hope though. I think people are learning from these experiences. And I don't think they are learning from just having it happen it to them, but the media is doing a decent job covering it. Unfortunately, there's also a lot of people learning about how unemployment works from first-hand experience. I was there once and I didn't want to go back. It directly lead to the creation of this website. This whole thought of hope came to me in the form of that second, minor experience that I mentioned above. I was watching an old episode of Clark Howard and he said the following in a clip on a radio show:

"I used to feel I had to convince people why they should be smart with their money. I don't have to do that as much any more. The mood of the country has changed."

When I first started writing about why MonaVie was a scam, a lot of distributors said, "Big deal, it's only $125 a month. I know my finances and I can afford that." I would love to be able to audit them and find out how many of them have a year of expenses in their emergency fund. I'd like to know how many have their retirement all squared away. The $125 per month, per person in a family of four turns out to be $5000 a year (there's some bulk discounts). I think people are now starting to take stock of what that $5000 a year would mean to them. We are talking aftertax money too. That's like giving yourself a $7500 at work. Who wouldn't want that?

I'm cautiously optimistic that America seems to be getting it. Perhaps America is as smart as my dog after all.

This brings me to the third experience - the Sucker Punch. I was watching the movie last night (scantily clad women fighting with swords is the kind of thing you can get away with when your wife is 2500 miles away) and while the long middle part of the movie dragged from too many fight scenes, I thought the ending was fantastic, perhaps one of the best I've seen. I don't think I'm giving anything away with this, but I'm going to leave you with the final sentence:

"You have all the weapons you need - now fight!"

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Posted on October 26, 2011.

Ask the Readers: Please Explain Occupy Wall Street to Me?

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Confession time... I don't watch a lot of news. In fact, I probably wouldn't watch the news at all, but it ranks high up there with my wife's favorite "shows." However, I did get myself out from under the rock to catch a bit about this "Occupy Wall Street" stuff. I would have likely written about it before, but I went to a conference to learn to be a better Personal Finance Blogger. As you might be able to tell, the first dose didn't take.

So today I'd like trick readers into educating me allow you to take the stage and tell me what this is all about. It seems like it might have something to do with the bank failings in 2008, but I missed that as well since I was in Australia at the time. If it were about that, it seems to me like the protests are about 2 years and 11 months too late.

Don't limit yourself to explaining Occupy Wall Street - tell me how you feel about it. I'm leaning towards agreeing with the movement. One thing giving me pause is that there are so many protests here in San Francisco and Berkeley that it is hard to take any of them seriously anymore.

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Posted on October 11, 2011.

Is Social Security a Ponzi Scheme? (Part 3: How to Fix Social Security)

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The following is a continuation of the Is Social Security a Ponzi Scheme? (Part 1) and Is Social Security a Ponzi Scheme? (Part 2: An Explanation of Social Security Works). Those articles explained the history of Charles Ponzi and the original Ponzi scheme and explained how Social Security works. In this article, we'll cover how to fix Social Security

How to fix Social Security

As explained in part 2, the demands of the baby boomers are putting a strain on the system. The current system is not sustainable without some changes (unless the US adopts a Logan’s Run sort of policy, which seems somewhat unlikely).

There are two sides to the equation – the taxes being taken in and the benefits being paid out.

One way to help pay for benefits would be to raise the tax rate, which is currently 6.2% of wages $106,800. This is levied on both the employee and employer, resulting in the government collecting 12.4% of these wages. Ratcheting the rate up a point or two would put more money into the coffers – but would be very unpopular with the voters. In fact the employee share of OASDI (Social Security) was temporarily dropped to 4.2% for 2011 in an attempt to jump start the economy.

Alternately, the cap could be removed so that all earnings would be taxed. No longer would the contributions of Alex Rodriguez be capped at $6621.60 (with an identically capped contribution from the Yankees).

There are three ways to balance the equation from a benefits perspective.

The first, and least popular, is to simply reduce the benefits the program pays out. This is a hard sell to voters (and older voters are more likely to vote than younger ones) as well as powerful lobbying organizations such as AARP.

The second method is to reduce the duration of payments. The government has already begun doing this. People born in 1937 or earlier are eligible for full benefits at age 65, while those born in 1960 or later are not eligible for full benefits until age 67 (chart here). Will we see further tweaks in the future? Perhaps someday you’ll need to wait until age 70 (or later) to receive full benefits.

Benefit payments could also be reduced by instituting a means test. The intent of Social Security is to serve as a safety net, rather than a full-fledged pension. Billionaire Warren Buffet is entitled to Social Security payments – but does he need a financial safety net? Of course not. As the general populations begins to pay more attention to the funding of their retirement, it’s possible than many people in the current generation will not need the safety net of Social Security.

The downside to the means test is that it may discourage people from taking care of their finances. Why bother to invest for your retirement when those who don’t will get bailed out by Social Security? That’s a very penny-wise and pound-foolish sentiment, of course. The prudent investor may be able to afford a house on the beach and lobster for dinner, while the person who ignored their retirement with the plan to be bailed out by Social Security may end up renting a room in a rundown part of town and cooking dinner in a hot pot. Still, it's the kind of thing that many Americans could consider.

My advice: invest with the assumption that you won’t receive any Social Security benefits. The odds of this are extremely unlikely to happen as unless it taken down completely people will still be paying into the system. I still plan for my retirement as if Social Security doesn't exist - simply because a lot can happen in the 30 years before I get to take it. If I do end up receiving benefits, that’s just frosting on the retirement cake.

I was thinking of ending the discussion of Social Security and Ponzi Schemes there, but I could probably be persuaded to write a few words on what some famous other people have said about Social Security and Ponzi Schemes. I'm looking for feedback to tell me whether you like the discussion or if I'm beating a dead horse here. Thanks!

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Last updated on October 1, 2011.

Is Social Security a Ponzi Scheme? (Part 2: An Explanation of Social Security Works)

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The following is a continuation of the Is Social Security a Ponzi Scheme? (Part 1). That article dealt with the history of Charles Ponzi and the original Ponzi scheme. In this article we'll cover the Social Security system in general.

Social Security also works best as a pyramid

There is one common thread that connects Social Security to a Ponzi scheme. Both work best when the investor base resemble a pyramid – with a few investors at first, gradually growing with each successive group. When this happens there are few complaints, because everyone gets their money - or in some cases much more than they originally contributed.

During the early years of Social Security, a natural pyramid was formed, due to a relatively short average length of retirement (simply because people died sooner) and large families. Unfortunately for the Social Security program, the base of the pyramid began to shrink in post baby boomer generations. People started to have smaller families - the successive group got smaller. Worse yet, due to the wonders of modern medicine people started to live longer, which meant that they could collect benefits longer.

Social Security is a pay-as-you-go system.

Naturally, the US government is not interested in creating a Ponzi schemes. Social Security's intention was to be a pay-as-you-go system, where the benefits for current retirees are paid by current workers, who will themselves become beneficiaries in the future (with their benefits paid for by the next group of workers).

At a superficial level, this sounds a lot like a Ponzi scheme. However, there are some very importance differences.

The first difference is that you don't have ownership of an "account" containing your investment and the accrued earnings. Those who invested with Ponzi and Madoff received financial statements showing their account balance and earnings. You won’t see this sort of statement from Social Security. While the Social Security Administration does provide statements to workers, these statements contain a projection of estimated payments – they do not contain an account balance. This is because you don’t have any ownership rights in the money you put into the Social Security system. What you have instead is the promise of payments that will be paid for by the generations of workers behind you.

Second, the goal of Social Security is transparent. You know that the money you pay in goes to pay the benefits of current retirees. This is no secret. If you aren’t aware of this, it’s because you weren’t paying attention in civics class. With a Ponzi scheme, you are deceived into believing that your money is being invested when in actuality it is being used to pay off earlier participants.

To clarify that above point, some of your money is being used to pay earlier investors. The operator of the scheme is also skimming some money off the top – outright theft. We all joke about congress raiding Social Security and leaving IOUs behind, but I doubt that many people truly believe that congress is going to gut the Social Security program and deposit the money into their Swiss bank accounts. There is no intention for the people who run Social Security to use the money to make themselves rich.

While the goal of a Ponzi scheme is to make the operator rich, the goal of Social Security is to ensure a safety net for all current and future generations.

The problems with a pay-as-you-go-system

Although most government-run pay-as-you-go programs have a noble goal, this does not mean they are perfect. The concept definitely has some flaws.

Ida May Fuller is the answer to a trivia question, and a pretty lucky lady. She was the first person to cash a social security check. Ida May had paid into the new system for three years. When she received her second check, she had received more in benefits than she had paid into the system. Ms. Fuller lived to be 100 years old, collecting nearly $23,000 in benefits. Not a bad deal, since she had paid in less than $25. (That’s not a typo. It’s not $2500 or even $250 – she paid in a Jackson and Lincoln).

Ida May wasn’t alone. The earliest recipients of the program earned substantially more in benefits than they paid into the system.

In the early stages of a pay-as-you-go system, the government is in a bit of a pickle. The government had to decide whether to pay the early recipients a fair benefit based on what the participants had paid in, or a reasonable benefit based on the intent of the program (to provide financial security in retirement). The U.S. government chose the second option. This meant that future generations would be subsidizing these early payments.

Why did the government choose to subsidize the early recipients? Probably to encourage support of the new system. Friends and relatives of Ida May and her contemporaries could hear for themselves how great the Social Security system was. The flip side would have been to pay the early recipients a couple of dimes every month – which wouldn’t have generated nearly as much buzz for the new system.

Pay-as-you-go systems are also at risk of changing demographics. There are two main risks of Social Security: that the number of people paying into the system will decline, and that the number of people receiving benefits will increase. The decline in family size in recent decades has lead to a decline in the number of people paying into the system – but so has the phenomenon of early retirement. Even worse, the early retirees are going to be toward the top end of wage earners – those paying the most into the system.

As the baby boomers receive benefits, it’s going to be the smaller generations of workers behind them paying the bill. To exacerbate the problem, advances in medicine coupled with people paying more attention to their health means that people are living longer than ever. Instead of receiving benefits for ten years, someone might receive benefits for thirty!

In the third installment of the series, we'll look at what can be done to the Social Security system deal with the problems of a changing society.

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Last updated on August 3, 2012.

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