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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