Monday, September 12, 2011

Social Security is essentially a Ponzi scheme

As with my post on Solyndra the other day, I feel obligated to ensure that as many people as possible understand that Social Security is essentially a Ponzi-like scheme and scam that is virtually guaranteed to be a horrendous investment.

It's ironic that Social Security's biggest defenders are also those who most profess concern for the welfare of the average Joe. That's because the average Joe would be far better off if he or she were able to invest his or her FICA contributions in a private investment account. You can see for yourself using the social security calculator here.

To understand why it's a poor investment, think of social security as an annuity (in which you pay some amount every month to purchase a monthly income stream that begins at some time in the future) that is not run by actuaries (who determine how much is needed to support those future obligations based on projected returns on investment) but instead by politicians (who are mainly interested in buying votes from today's generation), and whose underlying investments are not real investments but claims on some future generation's income. In a sense, Social Security is simply a tax masquerading as an annuity. Our politicians have over-promised and under-invested, leaving the social security system with an immense unfunded liability. And of course it should also be noted that your promised social security benefits are not an obligation of the U.S. government, and as such they can (and most likely will) be reduced in the future. Moreover, they are not an asset that you can sell or leave to your heirs, which means that those with shorter lifespans end up subsidizing those who live longer.

Michael Tanner of the Cato Institute has a nice, easy-to-understand explanation of why Social Security is a Ponzi scheme here, and which I reproduce almost completely because it is so good:

The original Ponzi scheme was the brainchild of Charles Ponzi. Starting in 1916, the poor but enterprising Italian immigrant convinced people to allow him to invest their money. However, Ponzi never actually made any investments. He simply took the money he was given by later investors and gave it to his early investors, providing those early investors with a handsome profit. He then used these satisfied early investors as advertisements to get more investors. Unfortunately, in order to keep paying previous investors, Ponzi had to continue finding more and more new investors. Eventually, he couldn't expand the number of new investors fast enough, and the scheme collapsed. Ponzi was convicted of fraud and sent to prison.
Social Security, on the other hand, forces people to invest in it through a mandatory payroll tax. A small portion of that money is used to buy special-issue Treasury bonds that the government will eventually have to repay, but the vast majority of the money you pay in Social Security taxes is not invested in anything. Instead, the money you pay into the system is used to pay benefits to those "early investors" who are retired today. When you retire, you will have to rely on the next generation of workers behind you to pay the taxes that will finance your benefits.
As with Ponzi's scheme, this turns out to be a very good deal for those who got in early. The very first Social Security recipient, Ida Mae Fuller of Vermont, paid just $44 in Social Security taxes, but the long-lived Mrs. Fuller collected $20,993 in benefits. Such high returns were possible because there were many workers paying into the system and only a few retirees taking benefits out of it. In 1950, for instance, there were 16 workers supporting every retiree. Today, there are just over three. By around 2030, we will be down to just two.
As with Ponzi's scheme, when the number of new contributors dries up, it will become impossible to continue to pay the promised benefits. Those early windfall returns are long gone. When today's young workers retire, they will receive returns far below what private investments could provide. Many will be lucky to break even.
Eventually the pyramid crumbles.
Of course, Social Security and Ponzi schemes are not perfectly analogous. Ponzi, after all, had to rely on what people were willing to voluntarily invest with him. Once he couldn't convince enough new investors to join his scheme, it collapsed. Social Security, on the other hand, can rely on the power of the government to tax. As the shrinking number of workers paying into the system makes it harder to continue to sustain benefits, the government can just force young people to pay even more into the system.
In fact, Social Security taxes have been raised some 40 times since the program began. The initial Social Security tax was 2 percent (split between the employer and employee), capped at $3,000 of earnings. That made for a maximum tax of $60. Today, the tax is 12.4 percent, capped at $106,800, for a maximum tax of $13,234. Even adjusting for inflation, that represents more than an 800 percent increase.
In addition, at least until the final collapse of his scheme, Ponzi was more or less obligated to pay his early investors what he promised them. With Social Security, on the other hand, Congress is always able to change or cut those benefits in order to keep the scheme going.
Social Security is facing more than $20 trillion in unfunded future liabilities. Raising taxes and cutting benefits enough to keep the program limping along will obviously mean an ever-worsening deal for younger workers. They will be forced to pay more and get less.

Don Beaudreaux has an excellent collection of thoughts and references on this same topic here, here, and here.


McKibbinUSA said...

I'm OK with cancelling Social Security -- however, I'd like the $100,000 plus in contributions I've made for the past 35 years back, thank you very much...

狂猪 said...

There are couple of problems with private investment account.

1. market volatility

Market volatility means the money may not be there when you need it. One of the reason many pension funds (managed by professionals) are in trouble today is because of the "untimely" great recession.

2. most people are poor at managing investments.

3. social security is also an insurance (i.e. an anuity). A private investment account is definitely not an insurance.

Living a long retirement life has one problem. You can run out of money to live on. By joining social security, the risk of living beyond your savings is spread out with the entire population.

Those who die before the average life span will consume less from the social security fund. Those that living above average life span will have the fund to support their life.

This is fair since no one can predict their own lifespan.

Benjamin Cole said...

Often forgotten is that Social Security also has a disability function (SSDI), and also death benefits for children. You "benefit" from that, although you may never use it. In fact, SSDI is widely abused, and people benefit from it who should not.

There are idealistic, naive and utopian visions of futures we could have, if humans were perfect. In the USA, Afghanistan, Iraq, Vietnam. These visions have cost us trillions upon trillions of dollars.

Can we phase out Social Security? Perhaps so. I fear my fellow Americans are not responsible enough, and too many would end up on the government dole anyway, unless we felt like letting old people starve to death. Maybe people would stop having lots of kids again as a form of social security.

And no one wants to wrestle with the reality that is Medicare and the need for euthanasia. No one in office anyway.

mmanagedaccounts said...

Giving almost 15% of one's earnings to the federal government in exchange for a small income during retirement is an abomination and robs citizens of a wonderful opportunity to create wealth and transfer it to the next generation.

A small portion of a private Social Security contribution could be used to purchase a term life insurance policy to protect spouse and children should one die before age of retirement.

Disability protection could also be purchased.

A private Social Security account is a way for people who live paycheck to paycheck to build some wealth to pass to their children. This could be a way for those who fail to build transferable wealth to do so.

A portion of the fund could be required to be in fixed income while the remainder could be in a conservative stock mutual fund, a bond fund or even a fixed annuity.

It is working for Chile and it could work in the U.S.

Build the wealth of citizens and not the government!

Public Library said...

The real problem is with modern banking and finance. Do we really want 100% of the population spending 30%+ of their productive capacity managing investments to protect against volatility and inflation from money printing?

Probably the worst reallocation of capital imaginable. It would make the 2002-2008 mal-investment in real estate look like a guppy pond...

PD Dennison said...

Social Security is a Ponzi scheme, but the reality has been morphing into another welfare program for sometime, as caps on income taxed go up, while payments have not.

The "Ponzi" label looks mild compare to the "Income-Redistribution-Welfare-Scheme" label that is coming...

Tom Gates said...

I am 57yo and 4 years ago I went back and added up all of my contributions to SS in my working life (yes, I have pay stubs going back!)I then doubled that amount to account for the employer contributions. I assumed an 8% annual rate of growth while working and 6% when retired and receiving benefits. My monthly benefit would be over $12,000 vs the $2300 I stand to get from SS. said...

Dr. McKibben, "I'd like the $100,000 plus in contributions I've made for the past 35 years back ..."

PLUS the lost investment returns on those dollars at, say 7% compounded return, which is about what the market has returned over the long term.

Benjamin Cole said...

A National Review writer embraces nominal GDP targeting. Very worth reading.

Unknown said...

Look up when Chile privatized their version of SSI. Dow was 800 then.

John said...

Dr. Bill:

Would you have made $100,000 to contribute to SS if you had lived in another country?

Chile's Gini zindex is in th 50s. A large portion of the population lives hand to mouth.

An 8% return on 0 is still 0.

TradingStrategyLetter - Weekly Summary said...
This comment has been removed by the author.
mike said...

I believe a fixed annuity is a safer bet than depending on social security.

Anonymous said...

Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. annuity rates