On behalf of all Social Security advisors, I'd like to thank Governor Perry for calling Social Security a Ponzi scheme during the Republican debates last week. By getting it out on the table, he gives us a chance to refute this long-held belief that the Social Security system is a scam and doomed to fail.
Here's what he said: "It [Social Security] is a monstrous lie. It is a Ponzi scheme to tell our kids that are 25 or 30 years old today you're paying into a program that's going to be there."
Never mind that he's spent the last week backpedaling on the statement lest he lose too many votes. But the words are out and the press is having a heyday with them, mostly in refutation. The New York Times published a very good explanation of why Social Security is not a Ponzi scheme, and the Washington Post published a primer on Social Security which you might find useful for explaining basic Social Security financing.
Your best resource, however, will come from the Social Security Administration itself, which published a piece in 2009 called Ponzi Schemes vs. Social Security.
Charles Ponzi rose to fame in the 1920s as a purveyor of foreign postal coupons. Claiming there was money to be made by arbitraging such coupons in international trading, he issued bonds that promised investors returns of 50% if held for 45 days or 100% if held for 90 days. The actual postal coupons returned only a fraction of a penny each. But that didn't matter. When the bonds of the first investors came due he paid them, along with their miraculous profit, using the money collected from the second round of investors. The news of these extraordinary profits swept up and down the east coast and thousands of investors flocked to Ponzi's office for an opportunity to give him their money. Using the money from this new surge of investors he paid off the next round of bonds as they came due, with their full profit, which excited even more frenzy.
Seven months later, it all came crashing down. On July 26th, 1920, at the insistence of the Massachusetts District Attorney, Ponzi quit accepting deposits from new investors. It was estimated that Ponzi had been taking in $200,000 a day of new investments prior to the halt. At that point he had already collected almost $10 million from about 10,000 investors. On August 13, he was thrown in jail. After about seven years of litigation, Ponzi's disillusioned investors got back 37 cents on the dollar.
Here's why Ponzi schemes never work. To pay a 100% profit to the first 1,000 investors you need the money from 1,000 new investors. Now there are 2000 "investors" in the scheme. To pay the same return to these 2,000 investors in the second round of payouts, you need the money from 2,000 new investors—bringing the number of participants to 4,000. And to pay these 4,000, you will need 8,000 "investors," then 16,000—and so on.
If all the investors stay in the scheme, the number of participants would double after every round of payouts. Even starting with only 1,000 "investors," by the 20th round of payouts you would need more new investors than the entire population of the U.S. Eventually, the number of new investors that would have to be found would exceed the population of the earth. But of course, Ponzi schemes always collapse long before they reach their theoretical limit as an ever-increasing number of new participants cannot be found.
Here's what he said: "It [Social Security] is a monstrous lie. It is a Ponzi scheme to tell our kids that are 25 or 30 years old today you're paying into a program that's going to be there."
Never mind that he's spent the last week backpedaling on the statement lest he lose too many votes. But the words are out and the press is having a heyday with them, mostly in refutation. The New York Times published a very good explanation of why Social Security is not a Ponzi scheme, and the Washington Post published a primer on Social Security which you might find useful for explaining basic Social Security financing.
Your best resource, however, will come from the Social Security Administration itself, which published a piece in 2009 called Ponzi Schemes vs. Social Security.
Charles Ponzi rose to fame in the 1920s as a purveyor of foreign postal coupons. Claiming there was money to be made by arbitraging such coupons in international trading, he issued bonds that promised investors returns of 50% if held for 45 days or 100% if held for 90 days. The actual postal coupons returned only a fraction of a penny each. But that didn't matter. When the bonds of the first investors came due he paid them, along with their miraculous profit, using the money collected from the second round of investors. The news of these extraordinary profits swept up and down the east coast and thousands of investors flocked to Ponzi's office for an opportunity to give him their money. Using the money from this new surge of investors he paid off the next round of bonds as they came due, with their full profit, which excited even more frenzy.
Seven months later, it all came crashing down. On July 26th, 1920, at the insistence of the Massachusetts District Attorney, Ponzi quit accepting deposits from new investors. It was estimated that Ponzi had been taking in $200,000 a day of new investments prior to the halt. At that point he had already collected almost $10 million from about 10,000 investors. On August 13, he was thrown in jail. After about seven years of litigation, Ponzi's disillusioned investors got back 37 cents on the dollar.
Here's why Ponzi schemes never work. To pay a 100% profit to the first 1,000 investors you need the money from 1,000 new investors. Now there are 2000 "investors" in the scheme. To pay the same return to these 2,000 investors in the second round of payouts, you need the money from 2,000 new investors—bringing the number of participants to 4,000. And to pay these 4,000, you will need 8,000 "investors," then 16,000—and so on.
If all the investors stay in the scheme, the number of participants would double after every round of payouts. Even starting with only 1,000 "investors," by the 20th round of payouts you would need more new investors than the entire population of the U.S. Eventually, the number of new investors that would have to be found would exceed the population of the earth. But of course, Ponzi schemes always collapse long before they reach their theoretical limit as an ever-increasing number of new participants cannot be found.
Social Security, on the other hand, is a "pay as you go" system. While it also uses the money from later participants to pay the earlier participants, the key difference is that it does not require a doubling of new participants to keep the system going. If 40 million workers are paying into the system and 40 million retirees are taking money out, and if the payroll taxes and benefits are relatively in balance—not 50% or 100% higher as Ponzi's payments were—the system can sustain itself forever.
A more accurate way to describe Social Security is that it is a system of transfer payments. Money from the younger generation is transferred to the older generation. Then when the younger generation retires and becomes the older generation, it receives money from the new younger generation. The payments to the older generation may seem to be much larger than the amount they paid in, but they are in line with what the younger generation is currently paying in. Then when that generation goes to collect, they will receive much larger payments too, because everything escalates with inflation.
If demographics were stable—that is, if each generation were the same size—no one would ever be tempted to call Social Security a Ponzi scheme. But there are several reasons why young people are being led to believe they won't collect any Social Security by the time they retire.
First, because the baby boomer generation of 76 million is so much larger than Generation X of about 46 million, it's easy to think that baby boomers will take it all and leave nothing to the next generation. But the Millennial generation that follows Generation X, also called the "echo boom," has 80 million members who are just now starting to work and pay into the system. These demographic variations are normal, and the purpose of the trust fund is to hold excess contributions from larger generations to pay benefits to smaller generations. Chief Actuary Steven Goss says that the problem of too many retirees for not enough workers that will cause benefits to drop to 77% of normal in 2036 is a one-time problem. If the system can be tweaked to take care of that one shortfall, the problem will be solved permanently (assuming people don't suddenly start having fewer children on a permanent basis).
Second, there's a "debt overhang" from the earliest recipients, who paid far less into the system than they took out. For example, Ida Mae Fuller, the first recipient of monthly Social Security benefits, paid a total of $24.75 in payroll taxes. By the time she died at age 100, she had received over $22,000 in benefits. This imbalance is being made up by all future generations who are essentially being forced to subsidize the earliest recipients. Pretty much everyone receiving Social Security now, except the oldest of the old who started working before 1935, has paid their fair share, so this debt overhang is about as large as it's going to be. There have been calls for the U.S. government to transfer enough funds into the Social Security system to make up for the overhang so the system is fair to everyone. But that's not likely to happen in this political environment.
Third, some people think Social Security should be abolished. Ultra right-wing conservatives see it as a welfare program and they are opposed to welfare of any kind. They would rather eliminate the payroll tax and have each individual be responsible for their own financial well-being. One way they attempt to gain support of their agenda to abolish Social Security is by convincing today's workers that they won't see a return of their payroll taxes.
And fourth, our own financial services industry must share some of the responsibility for denigrating Social Security as we've worked to convince clients to save for retirement. While the argument that Social Security will replace only a portion of your income has validity, many advisors and product sponsors have gone overboard, focusing on the diminishing ratio of workers to retirees and generally suggesting that people had better not count on Social Security. While the net effect may have been positive in that it has inspired people to save more for retirement, it often has resulted in a twisted and overly pessimistic view of Social Security.
A more accurate way to describe Social Security is that it is a system of transfer payments. Money from the younger generation is transferred to the older generation. Then when the younger generation retires and becomes the older generation, it receives money from the new younger generation. The payments to the older generation may seem to be much larger than the amount they paid in, but they are in line with what the younger generation is currently paying in. Then when that generation goes to collect, they will receive much larger payments too, because everything escalates with inflation.
If demographics were stable—that is, if each generation were the same size—no one would ever be tempted to call Social Security a Ponzi scheme. But there are several reasons why young people are being led to believe they won't collect any Social Security by the time they retire.
First, because the baby boomer generation of 76 million is so much larger than Generation X of about 46 million, it's easy to think that baby boomers will take it all and leave nothing to the next generation. But the Millennial generation that follows Generation X, also called the "echo boom," has 80 million members who are just now starting to work and pay into the system. These demographic variations are normal, and the purpose of the trust fund is to hold excess contributions from larger generations to pay benefits to smaller generations. Chief Actuary Steven Goss says that the problem of too many retirees for not enough workers that will cause benefits to drop to 77% of normal in 2036 is a one-time problem. If the system can be tweaked to take care of that one shortfall, the problem will be solved permanently (assuming people don't suddenly start having fewer children on a permanent basis).
Second, there's a "debt overhang" from the earliest recipients, who paid far less into the system than they took out. For example, Ida Mae Fuller, the first recipient of monthly Social Security benefits, paid a total of $24.75 in payroll taxes. By the time she died at age 100, she had received over $22,000 in benefits. This imbalance is being made up by all future generations who are essentially being forced to subsidize the earliest recipients. Pretty much everyone receiving Social Security now, except the oldest of the old who started working before 1935, has paid their fair share, so this debt overhang is about as large as it's going to be. There have been calls for the U.S. government to transfer enough funds into the Social Security system to make up for the overhang so the system is fair to everyone. But that's not likely to happen in this political environment.
Third, some people think Social Security should be abolished. Ultra right-wing conservatives see it as a welfare program and they are opposed to welfare of any kind. They would rather eliminate the payroll tax and have each individual be responsible for their own financial well-being. One way they attempt to gain support of their agenda to abolish Social Security is by convincing today's workers that they won't see a return of their payroll taxes.
And fourth, our own financial services industry must share some of the responsibility for denigrating Social Security as we've worked to convince clients to save for retirement. While the argument that Social Security will replace only a portion of your income has validity, many advisors and product sponsors have gone overboard, focusing on the diminishing ratio of workers to retirees and generally suggesting that people had better not count on Social Security. While the net effect may have been positive in that it has inspired people to save more for retirement, it often has resulted in a twisted and overly pessimistic view of Social Security.
