Social Security / Ponzi Comparison – is it fair?

Time after time, folks compare the Social Security system to a giant, government-sponsored Ponzi scheme. The argument is that current beneficiaries are paid by funds from new monies being added into the system. This is a broad description of how the typical Ponzi scheme works… but is this a fair comparison to Social Security? The other day I came across an article written by a fellow financial blogger, xrayvsn, who is a practicing radiologist. His blog can be found at xrayvsn.com, and he writes a lot of great stuff about the FIRE movement (Financial Independence / Retire Early), among other things. I think the blog is well-written and provides some really good information. You should give it a look!

So back to xrayvsn’s article, Is Uncle Sam Worse Than Bernie Madoff? This article takes us through a history lesson about Charles Ponzi’s legacy and how Bernie Madoff adapted it to his interests, and how both schemes ultimately failed with the proprietors subsequently jailed. With this backdrop, xrayvsn provides the reasoning behind his assertion that Social Security is, in fact, a giant Ponzi scheme. And I don’t disagree with what he says, up to a point.

Anatomy of a Ponzi scheme

The way a Ponzi scheme works is that the organizer (Ponzi, Madoff or others) gets the attention of investors, telling them of returns that can be had from their particular ploy. The returns advertised are generally above average, and are purported to be guaranteed or very low risk. Then as the first investors begin putting money into the system, the original investment activity does, in fact produce the expected better-than-average returns. Word of mouth causes more money to flow to the ploy. As the scheme develops and more and more money comes into the system, it becomes necessary to start paying out to the earlier investors with money that is taken in from new investors. This works just fine for a while, but at some point the scope of the ploy becomes too large to take advantage of the original arbitrage (in the case of Ponzi), or a systemic issue occurs which causes current investors to request liquidation (as in Madoff’s case).

In order for a Ponzi scheme to work, the inner workings of the “investment” are a closely-held secret – reason being that the organizer’s vast knowledge and inside tactics are what produces the returns, so publishing them would devalue the secrets immediately and it would all be over (and this is actually true, of course!). The other factor that has to be in place is that the newest, and in fact a high percentage of all current investors, are encouraged to continue to leave their investments on account – to continue earning the fabulous return.

At some point, a large number of investors ask for their money back. (Other ways a Ponzi scheme can come to an end include the organizer decides to take the money and run, or the inflow of new investors dries up.) Of course only a fraction of the “on paper” money is available to pay out, since the majority of new money has been paid out to the earlier adopters and others who, for whatever reason, requested a payout ahead of the herd. This is when the scheme is found out, the investors walk away with little or no money, and the organizer goes to jail.

Here are the main factors that must be in place for a Ponzi scheme:

1. Central organizer
2. Promise of better-than-average return
3. Guaranteed return (or extremely low risk)
4. “Secret” investment activity
5. Continuous inflow of new investors
6. Encouragement to not “cash out”

Comparison to Social Security

Taking the 6 factors listed above that describe a Ponzi scheme, how do these fit with Social Security? Let’s apply each one:

1. Central organizer ☑
2. Promise of better-than-average return ☐
3. Guaranteed return (or extremely low risk) ☑
4. “Secret” investment activity ☐
5. Continuous inflow of new investors ☑
6. Encouragement to not “cash out” ☑

So there are two items on our list that do not match up, #2 and #4. There’s a third that doesn’t match up exactly (#6), as well.

Regarding #2 – the “return” on your Social Security tax withheld (and your employer’s contributions) is not purported to be better than average. In fact, according to SSA, your benefits are expected to replace only about 40% of your pre-retirement income, and the larger your income, the lower that replacement figure is!

However, rather than the enticement of a better-than-average return, Social Security has something even better – it’s against the law to not participate (okay, there are a few exceptions). So in a way, Social Security has dealt with one of the eventual problems of Ponzi schemes: when the inflow new investors dries up. If you’re a US citizen with earned income (unless from a governmental or other exempt employer), you are required by law to “participate”.

And with respect to #4, the Social Security benefit calculations are readily available, and they are determined based on readily known facts: your earnings over your lifetime, and your date of birth. The underlying investment of monies that are used to pay benefits over time are well known (US Treasury securities) (whether you believe this or not is a debate for another time).

#6 in the list is debatable – I marked it as “checked” because there are inducements to participants that result in reduction of benefits by filing early, but there’s really no “encouragement” to not file. Plus, you can’t actually “cash out” of Social Security.

So, although Social Security has some very similar characteristics to a Ponzi scheme, I don’t completely agree with this assertion, for the three factors listed above, plus what I refer to below as the real difference.

The real difference

The real difference between Social Security and a Ponzi scheme is that a Ponzi scheme is promoted as an investment, while Social Security is insurance.

An investment is defined by Investopedia as

An investment is an asset or item that is purchased with the hope that it will generate income or appreciate in the future.

So, when investing, we purchase something (like a mutual fund) and hope it will appreciate in value or produce an income stream for us in the form of dividends.

Insurance on the other hand (according to Investopedia) is defined as

Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies and/or perils.

When we pay our homeowner’s insurance premiums, we actually hope we never have to file a claim. But we make these premium payments on the chance that our home might burn down, in which case we’d get a settlement to repair or replace the damaged property.

Social Security is actually a specific type of insurance, known as an annuity. Investopedia defines an annuity as

An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees.

With an annuity, we pay premiums expecting to receive a stream of payments in return. What we’re protecting against with an annuity is the chance that we’ll live longer than our paid-in premiums would have lasted us if we’d just kept them and used them for living expenses. This is protection against living too long.

Lastly, the other factor about the insurance provided by Social Security is that it is social insurance. Dictionary.com defines social insurance as

a system of compulsory contribution to provide government assistance in sickness, unemployment, etc.

We can take “etc.” to include retirement income benefits for our purposes in describing Social Security. Investing and most insurance is voluntary (to a degree), but social insurance is compulsory. It’s against the law to not participate (again, with a few exceptions).

So, while you might think about your Social Security tax payments as an investment (you may hope for income or appreciation), it’s actually an annuity (because it produces a stream of payments to you in exchange for your tax payments, and the stream of payments continues as long as you live). Social Security is a regressive taxation system (high income earners pay less SS tax as a percentage of total pay, because of the annual SS taxation cap) and a progressive benefit system (lower income beneficiaries receive a higher benefit in proportion to taxes paid in).

Insurance is (broadly) protection against economic loss or adverse event. Take auto insurance for example: You don’t expect a “return” from your auto insurance, in fact you hope to never have to use it. Using the auto insurance means that you’ve had some damage to your auto or damage to someone else’s property or person by your auto. However – if you only paid in one premium payment and then you total your brand new Maserati, you’ve had a pretty great return on the investment!

Annuities as insurance protect the participant against living longer than their assets can provide a stream of income. So the way to get a great “return” from your Social Security annuity is to live longer than the actuarially-determined average lifespan – of around 80-82 years. Live a lot longer than that and you might get a decent return on your investment. The lower your income was during your earning years, the better the return. But the key here is that the social aspect of this insurance and the progressive nature of the benefits guarantees that there will be many folks in middle to higher income strata that will receive a poor return (probably negative) on the overall activity.

The pyramid nature of Social Security

As also discussed in xrayvsn’s article, in order for the process to continue to pay out benefits, a problem arises when the number of new participants isn’t growing enough to continue paying the current and near-future beneficiaries. This situation is starting to come into focus as reported in the Social Security Trustees’ annual report. The 2018 Trustee’s report indicates that by 2033 the Social Security trust fund will be exhausted, and projected tax rolls at that time will only be enough to pay out approximately 75% of the promised benefits under current law, if nothing changes.

We’ve been here before, and this brief history lesson may tell something about the way this whole process works. Back in 1982, a similar report came from the Social Security trustees, indicating (as each annual report had previously for several years) that unless changes are made, beginning in 1983 there would have to be a reduction of benefits to current recipients. The rules in place had not substantially changed since the inception of Social Security in 1935, when the projection was that the system would remain solvent for at least 75 years.

It’s not surprising that a 75-year prediction only lasted 48 years. Look at all that happened in the intervening years: a world war, two more wars in Asia, man landed on the moon, the oil embargoes, and the list goes on. There’s no way the original plan could have anticipated the impacts all of those things would have on our world, let alone the Social Security system.

And guess what? At the last moment, before this apocalyptic reduction was necessary, Congress acted and passed sweeping Social Security reform laws – the most significant changes to the system since its inception in 1935, nearly 50 years before. The changes were expected, according to subsequent Trustee reports, to provide solvency of the Social Security trust fund for the coming 75 years (to approximately 2058). And guess what else? The changes enacted had very little impact on the current beneficiaries of benefits – in fact, the largest changes were pushed out to folks who were just entering (or yet to enter) the workforce at that time, those age 22 and under.

So here we are, looking ahead to a time that is remarkably similar – 50 years after the sweeping changes of 1983, and the prediction is eerily similar as well. If nothing changes, benefits will have to be reduced across the board.

And once again, it’s not surprising that the 75-year prediction is set to fall apart at around the 50-year mark. Back in 1983, there’s no way anyone could have predicted the Gulf wars, 9/11, the rise of the internet, among other catastrophes like the Kardashians; not to mention the impact to the Social Security system.

I predict that changes will be enacted, probably in 2032 or even 2033, and the changes will push back the impacts to yet another future generation, for the most part. There may be other changes that will impact certain portions of the beneficiary groups, but I’d expect those to be pushed out past the ages of those currently receiving benefits as well.

What do you think will happen?