Social Security Is Not a Ponzi Scheme

by Philip Brewer on 15 September 2011 40 comments
Photo: Andrew Malone

Once again, people are comparing Social Security to a Ponzi scheme. That's a bogus comparison. (See also: Don't Despair Over Small Retirement Savings)

A Ponzi scheme is a lie. Named after Charles Ponzi, it's a fraudulent investment where the operators report fake profits — and then support those illusory profits by paying out cash from new investors. Ponzi schemes always collapse eventually, because they depend on an ever-increasing number of new investors to provide enough cash to make payments to the old investors.

The reason that Social Security isn't a Ponzi scheme is that it isn't a lie. It keeps accurate books, attested to by a board of trustees and an actuary.

What Social Security is, is an inter-generational transfer. To solve a problem (old-age poverty), we as a society decided to transfer some income from workers to the elderly.

That worked pretty well for several decades. Then, in the early 1980s, the trustees realized that the baby boomers presented a problem. They were going to expect to receive a lot of money in two or three decades, but the workforce was going to be shrinking and there wouldn't be enough.

That problem was fixed in 1983. Benefits for younger folks were cut slightly, Social Security taxes were increased slightly, and for the next three decades money was set aside, with a plan to pay it out when the baby boomers retired. That money will have all have been paid out in just a few decades — but that's fine, because the next generation doesn't have the same kind of bulge of retirees.

See the difference? The Social Security Administration never pretended that investment returns were going to fund everyone's pension. They never lied and said that your contributions were waiting to pay your pension when you retired.

The issue keeps getting raised — usually by people who object to the whole idea and say "Ponzi scheme" to inflame emotions. But anyone willing to do a little research comes up with the same answer every time — as, for example, our own Xin Lu did in her 2008 post Is Social Security is Just a Grand Ponzi Scheme?

Social Security: Not a Ponzi scheme; an inter-generational transfer.

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Guest

You are correct of course :) but "inter-generational transfer" sounds like some mumbo-jumbo PC rubbish. Call it what it is -- a "pyramid scheme".

Guest's picture
Greg Longworth

It is a ponzi scheme it will eventually fail there isn't enough workers to support the program and your totally wrong. You can't continue to pay people 10 times the amount received for the amount they put in the system. This program has been a lie where it has been used for everything else it was suppose to be used for. There is 18 different programs that have been added to sucking the money away from this program. At one time there were 40 people paying to 1 person in receiving benefits and that ratio is down to 3 to 1. They system needs changed and the younger under 40 person needs to have a choice where to put their money after all it is their money to begin with.

Guest's picture
David M

Much of what you have to say is probably correct.

However, I do not think the first sentence is - that its a Ponzi Scheme.

It does need to be changed.

However, do you know what really needs to be changed - Medicare and Medicaid.

Guest's picture
Guest

"They never lied and said that your contributions were waiting to pay your pension when you retired."

Then why do so many people believe that's how Social Security works?

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Justin Valentini

You're right, Social Security is not a Ponzi scheme--it's worse.

A Ponzi scheme is a voluntary contribution; Social Security is required.

Guest's picture

So, not a Ponzi Scheme, but a redistribution of wealth... and that makes it OK? Also, if there is money set aside, why was there a threat (and some in the past) to stop the cheques? If there is money in some savings account just for SS, why would there be an issue?

Yes, I'm young (30) and do not expect to get SS because it's a non-sustainable system as it's setup. There needs to be major reform if it is to survive.

Guest's picture
Guest

Dude, as much as I'm sure that "redistribution of wealth" is a term that gets you all riled up, THAT IS WHAT GOVERNMENTS DO. They redistribute wealth. The roads you drive on were paid for with redistributed wealth. The schools you attended? Redistributed wealth - TAXES.

It's taxes. Taxes pay for **** that everyone uses. If you don't think that that's OK, then you probably need to find a libertarian paradise where you can fend for yourself.

Guest's picture
footmaster12

And with the absurdity of this post, I'm removing WiseBread from my RSS feed.

Guest's picture

I tend to disagree with you just a bit. You stated in part, ". . . and for the next three decades money was set aside, with a plan to pay it out when the baby boomers retired."

It is my understanding that the idea that money is set aside for SS is an urban legend. It is actually a pay as you go system and extra funds are used elsewhere. The very first SS recipients had paid little or nothing in and were paid by current workers at that time, and the process has continued to this day. The problem seems to be the ever decreasing numbers of workers contributing vs. the ever increasing numbers of retirees taking from the system.

Also, I think if we can put aside the thought that a Ponzi scheme is essentially where fake profits are reported, SS seems to be set up with the identical mechanics of a Ponzi, in that it requires continuous payments from current workers to fund current retirees.

However, I think that the argument that SS may or may not be a Ponzi scheme tends to muddy the waters and sends the discussion off track on what is needed to rectify the issues.

Guest's picture
Skip

The cash accounting methodology used by Social Security is not used by any other Fortune 500 company.

The change forced on the Post Office to go to an accrual based accounting system has caused all sorts of issues.

Social Security has 5.3 trillion in infunded liabilities(ie money that needs to be paid by our children). Hopefully, there will be enough jobs to support this.

Guest's picture
John Himmelein

i've been paying into social security since i was 17. it has been a significant amount from every pay check i've ever received. while the inter-generational transfer sounds a little iffy, social security is definitely no ponzi scheme. social security continues to be a great idea, though if you want to end it just give me back what i've put in over the past 40 years and i won't complain.

Guest's picture
Justin Valentini

"social security continues to be a great idea"

By what definition?

"if you want to end it just give me back what i've put in over the past 40 years and i won't complain."

That's the problem--your money isn't there. It's been given to current retirees and any surplus was already spent by the USG.

Guest's picture
David S

Phil, you look like an older guy, so maybe that's why you're not understanding the injustice many of your younger readers feel. Whatever you call Social Security, it's forcibly taking money from younger generations to pay older generations, and the way things are, will not return all of that money to them (only 76%). Whatever the reasons (slowing economic growth, smaller retiree/worker ratio), it's simply unfair and infuriating. I'd rather have control of the money so I can set it aside and invest in it myself. Even with the rates TIPS have now, at least I wouldn't be losing money!

Philip Brewer's picture

Thanks, everyone, for all the great comments!

Rather than responding individually, let me just say two things.

First, there's a principled argument to make along the lines of, "Social Security is a transfer payment; transfer payments are bad; therefor Social Security should be abolished." But that's a losing argument politically. (Evidence: people have been making it for as long as there's been Social Security and it hasn't been abolished.) That leads some people to call Social Security a Ponzi scheme—it's an argument that gets some traction politically. But it's not a principled argument. Social Security is not a Ponzi scheme.

Second, if you view Social Security as a transfer payment, then the arguments about whether it's viable or not become a lot more tractable. Social Security taxes bring in a certain amount of money and Social Security retirement benefits pay out a certain amount of money. Over time, those amounts have always been roughly equal (except for the period from 1983 until the baby boomers die off—as described, we had to make a special provision for them). Over time, those amounts will have to be kept roughly equal, which will not be hard, because both the tax rates and the benefit levels are set by law. Congress will just change the law as necessary to keep payments and receipts in balance.

In fact, it's instructive to look at why the levels aren't in balance right now. After all, the 1983 changes to the law were supposed to put Social Security on a sound footing for 75 years, but current projections show that we'll have to adjust things no later than 2036: we only got 53 years out of the last batch of changes, not the 75 we'd been promised. The reason has to do with the way wages have stagnated. If working-class and middle-class earned as much of the national income now as they did in 1983, Social Security would be in fine shape. But since so much more of the national income goes to rich folks (where it isn't taxed above about $100,000), we have the imbalance we've observed.

That imbalance will be easy to fix. It could be fixed a lot of different ways. Benefits could be cut slightly, such as by raising the retirement age a little or changing the way cost-of-living adjustments are made. Taxes could be increased slightly, such as by raising (or abolishing) the ceiling on the income subject to tax. I have no doubt that, sometime in the next decade or two, Congress will tweak the parameters a little bit and bring things back into balance.

Guest's picture
Justin Valentini

"If working-class and middle-class earned as much of the national income now as they did in 1983"

That's a pretty big conditional, no?

Philip Brewer's picture

Sure. But that's the sort of shift that makes it impossible to just set a tax rate and set some payout rules and then brush off your hands and say, "Done!" Instead, we have to accept that both payout and tax rules will evolve over time. It doesn't mean that the system is broken, it just means that nobody knows the future.

Guest's picture
Justin Valentini

Agreed. Nobody knows the future. Isn't that all the more reason to move away from this system and into a 401k-type system though?

Guest's picture

SS was initially established as a safety net and over the years it has morphed into a retirement plan. It should not be compared to other investment/retirement plans because it does not generate a return.

Our current dollars are used to fund current retirees - again there is no lock box and for those who say "just give me back my money and let me do as I please with it" I say you do not understand SS.

Guest's picture
timmy

Hang on there. Moving towards a 401k-type plan would introduce even more uncertainty into a basic social safety net for workers. 401k plans rely on investments made in the stock market and Wall Street's recent fluctuations don't make for a whole lot of confidence. Social security instead leverages the millions of workers and incomes in the US to provide for decades of stability.

A better way to think of Social Security is insurance. I don't pay an insurance company so that I can profit, I pay them to hedge against something happening that would hurt my ability to earn and support myself. With Social Security, I know that when I'm not able to work, I have some minimum financial support.

Guest's picture
Sean

A Ponzi scheme relies on new receipts to pay promised returns to its previous investors.

Seniors today receive promised returns from the government after paying into the system for, presumably, 40+ years. There are claims of a trust fund, even found on the SSA's website, but that was raided long ago. Currently, payments are funded entirely through payroll tax receipts. How is this not a Ponzi scheme again?

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Guest

This.

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joneric

What I find most unfortunate is how uneducated even politicians are. How can people with so many degrees get into power with so little financial common sense? Why is it the governments role to provide for a generation of individuals? Or why did those in power at the time believe they needed a program to pay for the lives of the elderly? I'm not saying they should be put out to pasture, or left hanging, rather, this was never the role the government was meant to play in the first place.

Its another step closer to socialism, which if you have ever studied other countries using that system they have always failed. I think better financial education would have done far more good to help the baby boomers than in effect telling them, "When you're older you'll be taken care of".

This belief only creates entitlement mentality, instead of the people figuring out how to create value in the world, even at an older age. I just hope that sooner rather than later, more people will take it upon themselves to educate themselves instead of looking to businesses and government for their well being.

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David M

" Its another step closer to socialism," - a long slow step I guess since Social Security has been making retirment payments since about 1935. When will Social Security tip us into Socialism? :)

Guest's picture
Greg

What's the alternative to Social Security?

I'm not trying to be facetious. Those people calling for the abolishment of Social Security, what's their proposed solution? Or are they saying no social safety net needs to exist?

Yes, Social Security is forced insurance (ie., "socialism"), but having some old people die penniless on the streets is not cool in the most advanced civilization in history. I'd like to think we aren't that coldhearted.

Guest's picture
Joneric

As I said first I think education is really the best way out of the current situation we find ourselves in. If everyone knew more about how to generate income there wouldn't be a need for government assistance programs like SS.

I don't think we should just dump it, or throw those on it out in the street. As for it leading to socialism and when.. who knows. What I do know is that each step towards it seems to justify or give people the idea that its "alright for just one more program".

As for a solution to retirement options I think that's done with permanent life insurance policies. They would be purchased on an individual basis, not given out by companies or corporations. Guaranteed increases, no taxes on distribution, keep money that you earn and still leverage its use- pay yourself back and you earn interest on it too. Bank on Yourself is a good book to read all about it.

Guest's picture
Moira

Hallelujah! I finally see someone other than myself shooting down the "Oh Noes! What about the Baby Boomers! They are draining all the SS!". It seems like no one ever looked into the SS commission that was put together in the 80s that anticipated the issue.

Now, if the War Chest would give back all the money it has "borrowed" from Social Security then we wouldn't have to have this false scare of it not being there for you when you retire...so let's get rid of it! *palm/face*

Guest's picture
Tony

Social security is a ponzi scheme because it is bankrupt and illegitimate. It's short on money because of a slowing population rate, aging population and mandated entitlement growth. The so-called "trust fund" is nothing more than govt IOUs--if you read the SSA's own FAQ they explain that all money paid into the trust fund by workers is spent immediately through the govt's general fund and replaced with "special securities" which is doublespeak for US Treasuries aka IOUs.

Retirees did pay into a bogus scheme and they're being rewarded for their foolish largess by sapping the productivity of young workers while bankrupting the entire nation.

Philip Brewer's picture

But a Ponzi scheme is a particular thing. Being bankrupt doesn't make you a Ponzi scheme. (And, of course, Social Security isn't bankrupt—it's making payments to retirees right on schedule, and there's no reason to think it won't go right on doing so.)

As for the Social Security trust fund money having been invested in US Treasury securities, why does that worry you? Do you think the US isn't good for the money? Even during the debt ceiling crisis, no one was suggesting that the US wouldn't make payments on the debt. (The question was whether not paying some of the other bills would nevertheless be a default.) If you're really worried that the US won't pay its debts, you're in a small minority: the US can currently borrow for 10 years at 2.06%.

Guest's picture
Guest

I would like to abolish the Social Security program. How? I don't really know how how. It's a program that never should've been started in the first place, but now it's so embedded into our culture, shutting it down could be crippling. I know that everyone is sitting there thinking- " this monster wants my grandmother living on the streets!" and that's not the case. If Social Security, and other programs on its level were cut, then people wouldn't be taxed as much, it would free up a lot of money to give to churches, and other charities to help the poor. Let's not forget that Social Security was supose to be added income, in retirement, and you were suppose to still manage your retirement yourself.

Guest's picture
Gary

Philip: 1st the government struggled to make sure SS retirees would get paid. What will happen when (not if) interest rates go to 10% or 18% like they did under Carter? What will happen when USA is paying interest on 25 trillion instead of only under 16 trillion? Government regulations, no oil drilling an no mining by government decree means income will be down reducing the funds to pay for the above. Are you aware the world is moving away from using the dollar as the world currency which means at that time we will no longer be able to print our way out of the mess? Our enemy the Chinese are cashing in their dollars to pay for their buildup to Challenge the USA. All this means the default may be unavoidable. Or the destruction of the rest of society to avoid a SS default.

Justin has the correct answer. Change all government pensions to 401k's with a pay in by the government for future retirees based on their earned credit for the pension. The pension could be generous and still save billions in future payouts. This will stabilize the government. Next place everyone under 50 on the 401k system. The first part of the taxes would go to current retirees and the next part would subsidize low income tax payers. The balance would be invested in the tax payers choice of safe investments of : government investments, Bank notes, stock funds of all the top stocks or other diversified stock choices. No individual stock, no penny stocks, and no high risk stocks. To answer the question, "Stock market safe are you crazy?" Over any 20 year period stocks have made gains. If the government could stop inhibiting business and the two items above helped our future economy stocks would go up. Also a side benefit is your spouse and heirs would receive the remains of your investment upon your death. If their are no heirs the money would subsidize the current retirees and low income tax payers.

Guest's picture
GE Miller

I always find it ironic how the very same people that bash something tend to take advantage of it when they are in a situation where they could benefit from it.

For example, I know a number of people who have called people on unemployment "lazy", "worthless", or "bums", but then when they lose their jobs do they file for unemployment? You bet they do.

For every social security basher here, I'd love to see you turn away your benefits if you're ever in a situation where you become disabled and cannot work or you find that your self-managed retirement account's returns has completely flopped and the only thing keeping you off the streets is your social security benefits.

Guest's picture
Justin Valentini

GE Miller,

Ignoring your straw man, what your points fails to address is the distinction between talking about what is and what ought to be. IMO, I see no irony/hypocrisy between the two.

For example, as a child I was forced to go to church even though I didn't believe in a god. But just because I sat in a pew and prayed (the is) didn't mean that I was a hypocrite for then criticizing the church, as I had no choice or consent in the matter.

Applying this to the argument at hand, I would love to turn away SS benefits but the government first has to let me opt-out of the program. If they force me to pay into a system that I don't want, can you blame me for taking advantage of the current system?

If you disagree with this assertion then I hope you're not a fan of Warren Buffett as he is the king of saying one thing and doing another. This can be seen by his repeated calls for higher taxes on the rich while he utilizes every accounting trick in the book to reduce his tax burden. Do you think he's a hypocrite for this? (Actually I do because no one is preventing him from paying more.) :)

Regardless, the point is that while there are many hypocritical people when it comes to tax policy, you can't blame someone for using of a system that they are required to pay into by law.

Cheers!

Guest's picture
Guest

Future Social Security (SS) payments will be funded by future tax payments. The trust fund holds no assets except the obligation of US taxpayers. At some point in the future, taxes will have to be raised or benefits cut. There is no getting around that.

I very much doubt taxes will be raised so I expect benefits will be cut. I would rather the government explain this better now than later like Greece. I believe that SS may be short of funds when I'm ready to retire in 25 years. I even receive a statement from SS every year that even says that is a possibility.

There are alternatives to Social Security. There is a very good one in place now called a 401k.

Guest's picture
Timmy

401k plans don't work. Really, they don't work. They're not working out for baby boomer retirees now, and they're don't going to work for future retirees as the sole retirement savings plan (myself included!).

1. You can't count on a 401k to get you out of a crisis situation like a medical emergency or disability. Yes, you can withdraw early usually without penalty for these situations, but that basically kills your savings then and there. When you're out of funds, you're out for life.

2. 401k's rely on the the health of the market *when you decide to withdraw funds*. So if the market is looking ugly when you want to retire, you're in trouble. Throw out that plan to retire at 60, because you'll have to work 'till 65 to weather the market. That's happening to retirees right now.

3. 401k's have no inflation protection. This makes most "safe" investments losing bets over the long term. By design, social security weathers inflation by increasing benefits based on shifts in the cost of living.

To be clear, 401k plans and social security are two different beasts entirely. Saying that 401k's are better than social security is straight up misdirection. It's a red herring because they serve different purposes.

401k plans are about sheltering your savings at tax-payers expense for generating profit the long term. It's an investment that may or may not pan out. There's a reason why 401k plan providers and fund analyses make no guarantee about future outcomes. It's always a gamble.

Social security is insurance that allows workers to make decisions that benefit the overall economy (like consumer spending and other investments like buying a home) without having to save for every unexpected outcome. It benefits older workers AND younger workers the same because social security is not just about providing retirement benefits, it's about providing for a minimum social safety net for workers.

Conflating the two as a public vs. private retirement plan (as many of the commenters do here) doesn't further the conversation about the merits or shortcomings of each program, and why either may be beneficial (or not) for workers.

Guest's picture

I think to make a statement that “401(k)s don’t work” is a generality that is a bit misleading. Retirement savings; be they 401(k)s, Roth or Traditional IRAs or non-qualified investments do work. The challenge is that one must contribute in much larger percentages than is currently occurring. The investor who contributes 3-4% each year and then blames the retirement vehicle is misleading himself/herself.

Saving and planning for retirement is hard and requires most of us to save 10% or better each year for decades. And while many cannot afford to do that, many others have simply chosen to live large in the present and not worry about the future except when it comes to complaining about their meager SS payouts.

You state that 401(k)s rely on “the health of the market *when you decide to withdraw funds*.” Of course they do – that is why we should practice asset allocation. If one keeps 100% of his/her funds in the stock market up until the retirement day, he/she is setting himself/herself up for failure.

You also state that “401k's have no inflation protection.” Again I would disagree. Keeping a portion of one’s funds in the stock market is the best way to provide inflation protection. Is that protection guaranteed? Of course not, but as students of finance understand, there are risks in every type of investment.

In conclusion, SS is a safety net, designed to keep you off the streets in your old age. It is not a retirement plan – that is your responsibility.

Philip Brewer's picture

You're both right. The 401(k) (and similar) plans are a fine way to save for retirement, but they're not a solution to old-age poverty.

The point of Social Security is not that it covers your pension needs—it does a pretty poor job of that. The point is that it ensures that the elderly and disabled are not destitute. For some decades now, it has done that very well.

Guest's picture

I agree that Social Security isn't a Ponzi scheme, but there's little doubt that it contains some very big promises that will be difficult to fulfill. In a way, it's best that we prepare for retirement as if it were a Ponzi scheme so we'll be ready for how ever things play out in the future. That means maximizing not only retirement savings, but also non-retirement savings. We should also work to lower expenses and get out and stay out of debt.

We should never have considered Social Security to be the be-all and end-all of retirement, what ever it's financial prospects.

Philip Brewer's picture

Although some people have ended up with no retirement income besides Social Security—through poor planning or bad luck—no responsible person has ever recommended such a strategy.

My own guiding principle was to organize my own retirement around three main sources of retirement income: my savings and investments (in 401(k)s, IRAs, etc.), a pension (no longer an option for most people), and Social Security. My goal was to arrange things such that I could meet my goals as long as two of those three paid off. I think I was fairly successful, although only time will tell.

Guest's picture
Frank

The difference between Social Security and a Ponzi scheme is the fact that a Ponzi scheme is voluntary and illegal and Social Security is mandatory and federally sanctioned. That's about it.

Guest's picture
Bruce

If a Ponzi scheme needs, by Phil's definition, an ever increasing stream of new investors to continue paying out, than Social Security may indeed be a Ponzi scheme. In 1950 there were 16.5 workers to every SS benificiary. By 1970 the ratio was 3.7 to 1. By 1990, 3.4 to 1, and in 2010, 2.9 to one. (From the SS website). We can either cut benefits, raise payroll taxes, or bring in new "investors". Otherwise, the system will face bankruptcy in the next 20 years.

“A lot of people in America think there is a trust — that we take your money in payroll taxes and then we hold it for you and then when you retire, we give it back to you.
But that’s not the way it works. There is no trust ‘fund’ — just IOUs that I saw firsthand.” President Bush, 2005

If it walks like a duck..........