Thursday, December 19, 2013

Is Social Security a Ponzi Scheme?

A Ponzi scheme, named for Charles Ponzi, creator of the first significant fraud of this sort is an operation that pays old investors with money from new investors rather than with profits from actual investments. Usually the con artist running a Ponzi scheme promises unusually high profits from some sort of mysterious financial mechanism that sounds reasonably plausible. For example a Ponzi operator may claim to have a secret computer program that allows him to predict the short term movements of the market with an unusually high degree of accuracy. He promises his marks a reasonable but high rate of return on their investment, perhaps 12%-15%.

The money starts to come in. The monthly account statements show a 12%-15% return compounding on a quarterly basis just as the charlatan promised. However, there is no magic computer program and no investments, just numbers printed on a page of paper. As word gets out new investors plow more money into the scheme. Most of the old investors are happy with the promises and their returns so they leave their money sitting inside the Ponzi scheme. Occasionally an old investor who wants to withdraw his money is paid off with some of the new money. All the time the operator of the Ponzi scheme is skimming big bucks off the action that are going into his pocket.

Finally, the Ponzi scheme reaches its day of reckoning. The operator takes all the money and vanishes into a South American sunset; too many investors get nervous and decide to withdrawal their money at the same time. Since the money isn’t there, the whole edifice comes crashing down in a single day. Innocent dupes lose all their money. Sometimes the perpetrator goes to jail. Sometimes he manages to escape justice.

I have been reading The Predictable Surprise (The Unraveling of the U.S. Retirement System) by Sylvester J. Schieber, former chairman of the Social Security Advisory Board. It is a difficult read due to the complexity of the topic, as well as my emotional reaction to the content. Without any particular political ax to grind, the author simply recounts the facts that have led us to where we stand today. It is truly disturbing that the players in this game knew the predicted outcome of their actions decades before the resultant problems became front page news.

I think I will need to read this book more than one time before I could write a complete coherent review. However, I did latch on to one key take away concerning Social Security. In 1935 when FDR began the Social Security System, he envisioned an insurance pool operated on sound actuarial principles. Money taken from workers’ paychecks would be invested in Government bonds. Interest would be paid on this principal. Then in old age the worker or his widow would receive his money plus interest. FDR knew if he sold the idea that Social Security was not a tax, no one could unravel what he had created. It was your money invested on your behalf for your retirement by the Government. When you were old you would receive, not a handout, but your money with interest.

Starting in 1939, a second view of Social Security funds gained the upper hand in Congress. Instead of an insurance pool, Social Security would be operated as a pay as you go system. Today’s retiree would not be receiving “his money” with interest, but instead would be receiving money directly from today’s workers. The benefit of this method was that the Government could spend the surplus collected on behalf of future worker pensions on today’s Government expenses. This would allow lower taxes or higher expenditures than might otherwise be politically palatable. The downside is that there was no pool of savings. Because there was no pool of savings, there was no interest being collected on any of these funds.

Like a Ponzi scheme, old investors were paid off with new investors’ money. The Social Security rate started at 2.25%. Today it stands at 12.9% with an additional 2.9% for Medicare on the first $113,700 of the taxpayer’s annual income. FDR and his associates did not believe that the American economy would tolerate anything in excess of 10% for Social Security. Gradually, the Social Security System included more and more workers until today almost all Americans are covered. The Baby Boom, the increase in the percentage of women in the workforce, and the increasing tax rates made everything thing appear that the Social Security System was indeed as some proponents of “pay as you go” method boasted, the Ponzi scheme that worked.

All Ponzi schemes work, until they don’t. Unlike the operator of a Ponzi scheme, the Government can demand higher taxes, change promised benefits, or just print more money that is worth less. As the Baby Boom moves into retirement, the retiree/worker ratio that started at 1 retiree for every 9 workers is headed for 1 retiree for every 3 workers. Starting in 2000 our remaining work force, due to stagnant wages, began to lose their traditional share of our nation’s GDP.

Fewer workers earning less money will be asked to support more retirees at the highest level of benefits ever paid in the history of the Social Security System. Let me add that life expectancy has increased from 64 years in 1935 until today it stands at 78 years. This would not have been a problem if our nation’s leaders had paid attention to FDR or even the parable of the grasshopper and the ant. In summer, prepare for winter. Instead, like the grasshopper in the story our leaders frittered away tomorrow’s money on today’s pleasures. Sometime in the next 30 years, depending on whom you choose to believe, the Ponzi scheme that has served this nation so well for so many years will begin to unravel. Taxes will be increased. Promised benefits will be taken away from old people who earned them. Already there is talk at the fringes of the American political system about nationalizing private 401(k) accounts to bolster the Social Security System.

I don’t know what will happen. I certainly hope that the Social Security System is preserved. My generation needs the money. The private pensions we expected to receive disappeared with changes in tax laws during the 1980s. This is another complex story covered in the book. For some of us options like the 401(k) and the Roth IRA arrived too late to do us much good.

I fear that Adam Taggart correctly commented on the potential effect of current levels of debt and unfunded liabilities in the developed nations of the world, like Social Security, when he stated, “We don’t have problems. Problems have solutions. We have predicaments. Predicaments have outcomes.”

Is Social Security a Ponzi scheme? There are certainly similarities, but there are also significant differences. I think sometime in the next 30 years we will receive a definitive answer to that question. I hope that sound actuarial science in the hands of politicians of good will from both parties will prove Adam Taggart wrong.

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