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

October 1, 2011 by Lazy Man 15 Comments

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!

Filed Under: Economy Tagged With: Ponzi Scheme, social security

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

August 3, 2012 by Lazy Man 18 Comments

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.

Filed Under: Economy Tagged With: Ponzi Scheme, social security

Is Social Security a Ponzi Scheme? (Part 1: Ponzi History)

August 3, 2012 by Lazy Man 19 Comments

As we head toward the 2012 election, you’ll probably hear more politicians echo the thoughts of Texas governor Rick Perry and call Social Security a Ponzi scheme.  The mouth of a politician isn’t always the best source of accurate information.  Is Rick Perry’s assessment correct?

Before determining whether or not Social Security is a Ponzi scheme, we need to cover a little Ponzi scheme history and understand how it works.

Who was Ponzi, and what was his scheme?

Charles Ponzi was a career criminal who stumbled upon his bright idea in 1919.  In theory, he was investing in international reply coupons.  International reply coupons were redeemable for first class international postage in any country that was a member of the universal postage union.  The international reply coupons bore different prices in different countries, due to differences in the underlying international postage rates.

Ponzi claimed to be making a profit by buying coupons in a country where the cost was low and selling them where the cost was higher.  In theory, it was definitely possible to generate a small (and legal) profit via arbitrage.

If you’re having trouble with the concept of international reply coupons, let’s use an analogy.  Imagine that Al’s car wash and Bob’s car wash use identical tokens.  Al sells the tokens for $3 and Bob sells them for $4.  You could make a profit by buying Al’s entire supply of tokens and selling them to Bob’s customers for $3.50.  Now, imagine that Al is Spain, Bob is Argentina, and the tokens can be used for international postage.

Ponzi claimed to need outside funds to get the ball rolling, and promised a 50% return on investment in 45 days – or 100% in 90 days.  (Skeptic question: if it was so easy to make a profit with international reply coupons, why didn’t Ponzi have competitors?)

What Ponzi was really doing, of course, was simply taking money from each new round of investors and using it to pay off the previous investors.  Most of the early investors didn’t even want their money back – they preferred to let it ride and continue to rack up huge amounts of paper profits.

Finally, Clarence Barron (yes, the guy the magazine is named for) analyzed Ponzi’s financials.  For Ponzi’s story to be true, the number of international reply coupons making their way through the Ponzi organization would need to exceed the actual number in circulation – by a factor of several thousand.

Oops.

Down came Ponzi’s scheme, a short nine months after it started.  In the nearly 100 years since Ponzi’s scheme, others have tweaked his initial design and run successful versions of their own.

You’ll often hear that a Ponzi scheme will quickly collapse, because the number of investors needed to perpetuate the scheme will quickly exceed the number of people on earth.  This is not exactly true.  The new investments don’t necessarily need to come from new investors – they could be from current investors doubling down on their “investments”.  The life span can also be extended if the operator isn’t actually paying the investors, but is simply crediting their account for the earnings.  Set the interest rate high enough and nobody will want to pull their money out.

In part two, we give an example how Social Security works. Finally, in part 3 we put the two pieces together to answer the question and determine whether Rick Perry was right or not.

Filed Under: Capitalist Ideas, Economy Tagged With: Ponzi Scheme, social security

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