Is Social Security A Ponzi Scheme?

Texas Governor Rick Perry made headlines last week at the Republican presidential candidates’ debate when he asserted with an imperious tone that Social Security is a Ponzi scheme. It’s a tempting analogy because most of the payments to retirees are financed out of receipts from payroll taxes imposed on current workers and employers, not out of principal and earnings on funds contributed by those retirees during their working careers. So why is Perry wrong?

Ponzi schemes are named after Charles Ponzi, who duped thousands of investors in a postage stamp speculation gambit back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme but quickly switched to using incoming funds to pay off earlier investors.

The popular notion of a “Ponzi scheme” has expanded to include any investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Organizers often misappropriate funds contributed by early-stage investors for their own personal use instead of engaging in any legitimate investment activity. Because the early contributions are not actually invested, each generation of later investors must make greater investments than the prior one to pay back principal plus the promised return. Eventually the scheme collapses because the perpetrator of the fraud cannot con enough new investors to pay the prior generation of suckers.

Like a Ponzi scheme, Social Security relies upon money from new participants to pay a substantial part (about 82%) of amounts due the prior generation of participants ($727 billion in 2011). (The other 18% comes from interest on trust fund investments and income taxes on social security income.)

Unlike a Ponzi scheme, Social Security is transparent, with no element of fraud. The program was funded for a few years in the 1930s before payouts began in 1940 and operated at a surplus until this year, creating a $2.6 trillion trust fund to supplement future collections.

Unlike a Ponzi scheme, participation in Social Security is mandatory, assuring that current employees will have a pool of future employees to help fund their payouts.

The risk to the solvency of Social Security is not fraud but changing demographics. People are living longer, and the birth rate is low. In 1955, there were over eight workers for every Social Security beneficiary. Today, there are only 2.9 workers per beneficiary, and by 2036, that ratio will decline to 2.1. By 2036, there will be almost twice as many older Americans as today (78.1 million vs. 41.9 million). We’re only just now reaching the tipping point where payouts exceed trust fund collections and income, but this shortfall is projected to continue each year hereafter. The trust fund is projected to be sufficient to allow for full payment of scheduled benefits until 2036, but then payouts would be limited to collections unless adjustments are made to the system.

We do need to make changes to reflect our new demographics, but these revisions do not require blowing up a program that has formed the bedrock of most workers’ retirement plans for the past 70 years. In fact, current proposals under study by the Social Security Administration to switch from wage-based indexing of initial benefits to price-based indexing would assure program solvency for the foreseeable future while maintaining the purchasing power of social security payouts across generations. (Under the current system, future generations would receive payouts with greater purchasing power.)

In my view, the solvency of Social Security is a problem that should not be ignored, but the more serious fiscal dilemma we face is rising health care costs. The solution there will most likely involve rationing of care, an issue fraught with political risk. My latest novel, King of Paine, touches on the moral aspects of some of these end-of-life issues (in the context of a suspenseful whodunit), and a future post will take a harder look at the tragic choices we may have to make. Stay tuned.