Social Security, Ponzi Schemes, and the Need for Reform, Cato Policy Analysis No. 689

8/3/2019 Social Security, Ponzi Schemes, and the Need for Reform, Cato Policy Analysis No. 689

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Executive Summary

Recently there has been much debate overwhether Social Security is or is not a Ponzischeme.

Clearly Social Security has many structuralcharacteristics that resemble those of the clas-sic Ponzi or pyramid scheme. For example, like aPonzi scheme, Social Security does not actuallysave or invest any of a participants payments.When a worker pays taxes into the system, that

money is used to pay current beneficiaries.Therefore, participants receive payments, notfrom returns on their own investments, butdirectly from inflows from subsequent partici-pants.

As a result, Social Security was able to payearly participants a windfall return on theirmoney. But as demographic changes result infewer workers paying into the program andmore recipients taking benefits out, the returnto subsequent generations grows steadily worse.Todays young workers will receive a rate of re-

turn far lower than what they could receivefrom private markets.

However, there is one crucial distinction be-tween Social Security and a Ponzi scheme. OncePonzi was unable to talk enough people into in-vesting with him, his scheme collapsed. Peopleparticipate in Social Security because the gov-ernment makes them. And if the Social Secu-rity system begins to run short of people payinginto the system, as it is now, it can always forcethose people to pay more.

Yet, Congresss ability to preserve Social Se-curity through higher taxes and lower benefitsshould not distract from the more fundamentalproblem that the programs Ponzi-like struc-ture makes it unable to pay currently promisedlevels of benefits with current levels of taxation.In short, the program is facing insolvency with-out fundamental reform.

Instead of just making a bad deal worse, thatreform should fundamentally restructure So-cial Security. It should remove the Ponzi-like as-pects of the program and allow younger workers

to save a portion of their payroll taxes throughprivately invested personal accounts.

Social Security, Ponzi Schemes,and the Need for Reform

by Michael Tanner

No. 689 November 17, 2011

Michael Tanner is a senior fellow with the Cato Institute and director of the Cato Project on Social SecurityChoice, and editor of Social Security and Its Discontents: Perspectives on Choice (Washington: CatoInstitute, 2004).


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Milton Friedmancalled SocialSecurity thebiggest Ponzi

scheme on earth.

Introduction

Ponzi Scheme: a fraudulent invest-ment plan in which the investmentsof later investors are used to pay ear-

lier investors, giving the appearancethat the investments of the initialparticipants dramatically increase invalue in a short amount of time.

Wests Encyclopedia of American Law

In his book, Fed Up, Texas governor RickPerry claims that Social Security is set uplike an illegal Ponzi scheme.1 He explic-itly compares Social Securitys financing tothe type of illegal scheme that sent Bernie

Madoff to prison, explaining that, like aPonzi scheme, Deceptive accounting hashoodwinked the American people intothinking that Social Security is a retirementsystem and financially sound when clearly itis not.2

Perrys statement has been roundly de-nounced by other Republican candidates,especially former Massachusetts governorMitt Romney, as well as many Social Secu-rity advocates and portions of the media.

It is not as though Perry was the first to

observe that Social Security has many of thecharacteristics of a Ponzi scheme. For exam-ple, Milton Friedman called Social Securitythe biggest Ponzi scheme on earth.3 So didhis fellow Nobel laureate Paul Samuelson,who famously referred to Social Security asa Ponzi scheme that works.4 Even some ofthe programs most ardent defenders haveused the term. For example, Paul Krugmanwrote of Social Securitys Ponzi game as-pect, in which each generation takes moreout than it put in.5

Others suggest that Social Security is atleast Ponzi-like. The Economist says that abetter term for Social Security would be apyramid scheme, which [Websters] diction-ary defines as a usually illegal operation inwhich participants pay to join and profitmainly from payments made by subsequentparticipants.6 Boston University econo-

mist and former Clinton administrationofficial Laurence Kotlikoff prefers to likenSocial Security to a chain letter.7

Whatever the terminology, these econo-mists and commentators base their descrip-

tions on the basic structure of Social Secu-rity, under which, as The Economist notedfuture workers do have to generate the taxrevenues that pay the benefits of future pen-sioners, and that is a problem if one genera-tion is smaller than the one before.8

So the question remains, is Social Secu-rity a Ponzi scheme?

The Original Ponzi Scheme

To answer that question, we must con-sider how a Ponzi scheme works. The opera-tor of the Ponzi scheme recruits investors,promising high returns on their investmentor contribution. But the operator does notactually invest the money, and instead pock-ets it for himself. Because no investmentsare made, the schemes operator can onlypay returns in one of two ways: 1) return aportion of the investment as interest orprofit, while convincing the investor tokeep his principle invested; and 2) recruiting

new investors and using their money to paythe earlier ones. However, these new inves-tors will now have to be paid, requiring theoperator to recruit a third round of inves-tors large enough to pay for both the initialand secondary investors. This continues un-til the operator is no longer able to recruitsufficient new investors and the system ulti-mately collapses.9

Ponzis scheme was not the first suchswindle, but it was the classic model that hascome to define such plans, as well as their

near identical cousins, pyramid schemes andchain letters.

In December 1919, Carlo Charles Ponziapproached a group of friends and acquain-tances in Boston with a new investmentopportunity.10 Ponzi claimed that he hadfound a way to make money by exploitingpostal rates between countries, using post-


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Many Americanstill mistakenlybelieve thattheir SocialSecurity taxesare somehowsaved for theirretirement.

age coupons that were then widely availablefor use in purchasing stamps. At the time,postal systems worldwide offered couponsthat could be used to purchase stamps forreplying to a letter, roughly the equivalent of

a postage prepaid envelope. While the cou-pons were supposed to have a fixed value re-gardless of their country of origin, the postWorld War I devaluation of many Europeancurrencies created an arbitrage opportunity.Ponzi proposed buying coupons on thecheap in countries such as Spain and thenusing them to purchase postage in coun-tries like the United States, where they wereworth more. It might be considered similarto playing international currency marketstoday.

In reality, however, while there was a logi-cal argument to be made for Ponzis propos-al, he had already tried and failed to makemoney at such a scheme, defeated by the in-ternational postal systems bureaucracy andred tape. Administrative costs ate up anyprofits, while continual bureaucratic delaysprevented him from moving money aroundfast enough to take advantage of fluctua-tions in coupon values.

But Ponzi did not reveal this failure to hispotential new investors. Instead, he prom-

ised them that for every $100 they invested,he would guaranteein writinga returnof $150 within 90 days. And he appeared todeliver. Not only did Ponzis initial investorsreceive their 50 percent return, often well be-fore the 90-day term, but he soon increasedhis guarantee to a 100 percent profit within90 days. As word spread, the money pouredin, more than $9 million in eight months.

Ponzis secret was that he was not actu-ally buying postal coupons with the moneyor making any other investments. Instead,

he was simply using the investments of laterinvestors to pay returns to his earliest inves-tors. At the height of his plans popularity,with thousands of potential investors linedup to give him money, this was relativelyeasy to do. Eventually more than 20,000people invested with him, at one point con-tributing as much as $200,000 per day.

But by the summer of 1920, skepticalnewspaper articles and a legislative investi-gation were making it more difficult for himto continue attracting enough new investorsto maintain payouts to the growing number

of investors that needed to be paid. In Au-gust, after aBoston Globe expos revealed thatPonzi had previously been arrested for forg-ery in Canada and raised additional ques-tions about his business model, there was arun on Ponzis offices by investors demand-ing their money back. On August 9th, Ponziadmitted that he had no assets with whichto pay them and filed for bankruptcy. Fourdays later he was arrested by federal agents.Ponzi was eventually convicted of fraud andserved four years in federal prison.

Social Security as aPonzi Scheme

Some defenders of the current systeminsist that Social Security cannot be a Ponzischeme because, as USA Today editorialized,Ponzi schemes are a criminal enterprise;Social Security is not.11 But this is simplya tautology that says nothing about the pro-grams structure.

Other defenders point out that Ponzischemes are, by their very nature, fraudu-lent, making promises that the schemesoperator has no intention of keeping. More-over, the operators lie about whether or notthey are investing the participants money.Social Security, on the other hand, they say,is transparent, honest about its structure,and honest about the benefits it will deliver.In one widely cited column, political bloggerJonathan Bernstein put it this way: [S]ayingthat Social Security is a Ponzi scheme or is

like a Ponzi scheme is basically a false accu-sation of fraud against the U.S. governmentand the politicians who have supported So-cial Security over the years.12

Here, the programs defenders are on evenshakier ground. While the Social Security Administrations website and official pub-lications are indeed straightforward about


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Social Securitydoes promisebenefits that

the governmentknows it cannot

deliver.

how the program operates, many Americansstill mistakenly believe that their Social Se-curity taxes are somehow saved for their re-tirement. One only has to listen to any So-cial Security debate where seniors assert that

they are getting back what they paid intothe system to realize that many recipientsare not clear on the programs financing.Social Securitys use of terminology, suchas Trust Fund, has perpetuated much ofthis misunderstanding. Again, witness howmany Americans believe that Social Securityis in trouble because the government hasspent, borrowed, or looted the money thatshould be in the Trust Fund. According toa recent Rasmussen poll, just 10 percent of voters know that Social Security taxes are

not reserved for Social Security payments.13

More significantly, in keeping with theearlier definition of a Ponzi scheme, SocialSecuritydoes promise benefits that the gov-ernment knows it cannot deliver. For ex-ample, if a worker uses the Social Security Administrations Benefit Calculator, heor she will receive an estimate of his or herSocial Security benefits under current law.14However, given current levels of financing,the Social Security system cannot pay thosebenefits in full after 2037. In fact, by law,

benefits would have to be reduced by 24 per-cent after that date.15

From 1999 until March of 2011, this ben-efit estimate was mailed to workers annual-ly. During the Bush administration, the Per-sonal Benefits Statement (PEBS) containeda disclaimer that:

Your estimated benefits are basedon current law. Congress has madechanges to the law in the past and cando so at any time. The law governing

benefit amounts may change because,by 2037, the payroll taxes collectedwill be enough to pay only about 76percent of scheduled benefits.16

This warning was discontinued when the So-cial Security Administration stopped mail-ing paper copies of the benefit statement,

and it is not included in the online calcula-tor. While the Social Security Administra-tion website includes discussions of the pro-grams financial problems elsewhere on thesite, someone looking for what his or her

benefits will be would not be told that So-cial Security cannot pay the listed benefit And even during the Bush administrationthe disclaimer was on a separate page of thePEBS from the listed benefit level, and bur-ied within a lengthy text. Small print asidethe Social Security Administration is provid-ing a misleading promise of benefits.

Defenders of Social Security also suggestthat the investment structure of the pro-gram is irrelevant because Social Security re-sembles an insurance program more than

it resembles an investment plan. As the LosAngeles Times puts it, Its not a retirementsavings program; its an insurance plan de-signed to help the elderly, the disabled, andtheir families stay out of poverty.17 Buteven if one accepts the definition of SocialSecurity as insurance, that is a description ofbenefits and how they are determined, notof financing.

Indeed, insurance companies are re-quired to maintain reserves and capital andsurplus at all times and in such forms so as to

provide an adequate margin of safety.18 Al50 states impose capital reserve requirementson insurers, guaranteeing their ability to payclaims. Typical is New York, which mandates,Every insurer shall . . . maintain reserves inan amount estimated in the aggregate to provide for the payment of all losses or claimincurred.19 No insurance company could le-gally plan to fund future claims out of futurepremiums. An insurance company that didso would resemble a Ponzi scheme. Yet, thatis very close to how Social Security promises

to pay future claims to its benefits.Finally, some defenders of Social Security

suggest that the program shouldnt be com-pared to a Ponzi scheme because, unlike aPonzi scheme, Social Securitys purposes arebeneficent. As Perrys rival, former Massa-chusettss governor Mitt Romney, says, theprogram is a recognition that we want to


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Social Securityresembles aclassic Ponzischeme in manyaspects.

care for those in need, and our seniors havethe need of Social Security.20 But the im-plication of this argument is that, if CharlesPonzi had given his proceeds to charity, orif he had really believed that he could payprofits to his investors, there would havebeen no problem with his scheme. Clearly,intent and outcome are two different things.

None of these arguments deal with theunderlying question of Social Securitys fi-nancial structure. Even if one concedes thatSocial Security is a legal, transparent, andbeneficent insurance scheme, if it is set upstructurally as a Ponzi scheme it will ulti-mately fail. And it is in this structure that,with one important distinction, Social Se-curity does indeed resemble a Ponzi scheme.

Social Security is apay-as-you-go (PAYGO)program, in which Social Security taxes areused to immediately pay benefits for current

retirees. It is not afunded plan, where contri-butions are accumulated and invested in fi-nancial assets and liquidated and convertedinto a pension at retirement. Rather, it is asimple wealth transfer from current workersto current retirees.

Table 1 shows a basic model of overlap-ping generations, where people are born in

every time period, live for two periods (thefirst as workers, the second as retirees), andfinally die. As time passes, older generationsare replaced by younger generations. Thecolumns represent successive time periods,and the rows represent successive genera-tions. Each generation is labeled by the pe-riod of its birth, so that Generation 1 is born

in period 1, and so on. In each period, twogenerations overlap, with younger workerscoexisting with older retirees.

In Table 1, a PAYGO pension system pro- vides a start-up bonus to Generation 0 re-tirees by taking contributions from Genera-tion 1 workers to pay out benefits to thosealready retired. The PAYGO program pro-vides initial (Generation 0) retirees a wind-fall because they never paid taxes into thesystem. Subsequent generations both paytaxes and receive benefits. There is no direct

relationship between taxes paid and benefitsreceived.21 As a result of this structure, SocialSecurity resembles a classic Ponzi scheme inmany aspects.

There is no investment. Like a Ponzischeme, Social Security does not actuallysave or invest any of a participants pay-ments. When a worker pays taxes into the

Table 1

A PAYGO Social Security System

Period 1 Period 2 Period 3 Period 4

Generation 0Retired

benefitsDead Dead Dead

Generation 1Working

contributions

Retired

benefitsDead Dead

Generation 2 UnbornWorking

contributions

Retired

benefitsDead

Generation 3 Unborn UnbornWorking

contributions

Retired

benefits

Generation 4 Unborn Unborn UnbornWorking

contributions

Source: Thomas Siems, Reengineering Social Security for the New Economy, Cato Institute Social Security Paperno. 22, January 23, 2001.


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Trust Fundaccumulations

are spent like anyother government

revenue.

system, that money is used to pay currentbeneficiaries. Since Social Security beganrunning a cash-flow deficit this year, payingout more in benefits than it takes in throughtaxes, every dollar collected in Social Securi-

ty taxes (and more) is used to pay benefits.

22

There is no money left over to invest. Andsince Social Security is currently projectedto never return to surplus, there will be nofuture investments.

However, what about the surplus SocialSecurity taxes that accumulated in the So-cial Security Trust Fund from 1984 to 2010,a period when Social Security did collectslightly more in taxes than it paid in ben-efits? Could that have been considered asinvested?

When Social Security was running a sur-plus, the excess revenues were used to pur-chase special-issue treasury bonds. Whenthe bonds were purchased, the Social Secu-rity surplus became general revenue and wasspent on the governments annual generaloperating expenses. What remained behindin the Trust Fund were the bonds, plus aninterest payment attributed to the bonds(also paid in bonds, rather than cash). Cur-rently the Trust Fund holds roughly $2.9trillion in such bonds. Those bonds are, in

essence, a form of IOU, a promise againstfuture taxes. When the bonds become due,the government will have to repay them outof general revenue.

Since Trust Fund accumulations arespent like any other government revenue,the Social Security Trust Fund could beconsidered an investment to the degreethat general government spending could beconsidered investment. But relatively littlefederal spending meets that definition, in-cluding infrastructure and some education

spending. Most government spending issimply transfer payments or other forms ofconsumption. In fact, by the governmentsown estimates, only 15.7 percent of federalspending can be considered investments.23Since the maximum Social Security surplusrepresented just 15 percent of Social Secu-rity taxes, an investment rate of less than 16

percent of federal spending means that lessthan 2.5 percent of Social Security taxes wereever invested in anything.

Taking a slightly different tack, otherssuch as Center for American Progress blog-

ger Matthew Yglesias, argue that all So-cial Security taxes should be considered tohave been invested in the U.S. economy asa whole, since recipients are ultimately re-lying on the fruits of that economy to paytheir benefits. He claims that Social Securityis similar to private pensions or even 401(k)plans in this sense. With stocks or other pri-vate investments, he writes:

Your expectation is that at a futuredate . . . youll be able to exchange

those shares for money. More moneythan you paid for them in the firstplace. Why would that work? Well,it could work because you were juststupendously lucky. But the reasonwe anticipate that it will work sys-tematically is that we anticipate thatthere will be economic growth. In thefuture, people will in general havemore money, so assets will be morevaluable.24

Yglesias goes on to argue that the samecan be said of Social Security:

Its actuarial situation is just the sameas a stock market investment in thisregard. If future economic growthis lower than anticipated, it will beimpossible to pay the anticipated levelof benefits. On the other hand, iffuture economic growth is faster thananticipated, it would be possible topay even more benefits than had been

promised.25

It is true that, whether you are talkingstocks or Social Security, returns are ulti-mately a claim on the wealth produced by fu-ture generations. The future value of stocksbonds, property, and other investments isultimately dependent on future cash flows


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Social Securityis simplya transferprogram, feedinconsumptionrather thaninvestment.

such as dividends, interest, and rents. Theyare, in turn, dependent on economic growth.If economic growth in the future is poor, thetaxes available to pay Social Security will notbe available, but asset values will likely also

decline.However, this analysis ignores the fact

that in a dynamically efficient economythe rate of return on labor, the basis for thepayroll taxes that will be used to pay futurebenefits, is lower than the rate of return oncapital, the basis for investment returns. AsFigure 1 illustrates, in the United States thereturn on capital has generally run about 2.5percentage points higher than the return onlabor.

Yglesiass analysis also ignores the impact

that private investment has on economicgrowth. Whereas, as shown above, SocialSecurity is simply a transfer program, feed-ing consumption rather than investment,private pension programs do invest theircontributions, thereby boosting economicgrowth. In fact, Martin Feldstein and othershave suggested that Social Securitys impact

may actually be worse than no investment.Because individuals substitute Social Secu-rity for private savings, the program actu-ally displaces savings and investment thatwould otherwise occur. Feldstein, for exam-

ple, suggests that if the amount currentlypaid in Social Security taxes were instead in-vested privately, it would increase the eco-nomic well-being of future generations byan amount equal to 5 percent of GDP eachyear.26

Earlier investors win big. Like a Ponzischeme, Social Security paid early partici-pants a windfall return on their money.There are two reasons for this.

First, because individual Social Securitytaxes are not saved or invested for that in-

dividuals retirement, the Social Securitybenefits that the individual receives are notdirectly linked to the taxes paid. As the Su-preme Court ruled in Flemming v. Nestor(1960), this means that people have no legal,contractual, or property right to benefits.27Congress can change, reduce, or take awaythose benefits at any time. However, it also

Figure 1

Return on Capital vs. Return on Labor 19702010

Source: Authors calculations using Social Security Adminstration data Table V.B2 and Table V.B1.


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The SocialSecurity benefitsthat individuals

receive are not

directly linkedto the taxes they

paid.

means that Congress can set a minimumbenefit level that is also unrelated to contri-butions.

That is what Congress did in the case ofSocial Securitys earliest recipients. As Ed-

ward Witte, executive director of FranklinRoosevelts Committee on Economic Secu-rity, told the House Ways and Means Com-mittee in 1935, if benefits were proportionalto contributions:

The man at $40 [in wages per month]will get a pension of around 20 centsa month after 5 years of contribu-tions, which is such a small amountthat it would not be considered sat-isfactory. . . . Although the actuaries

may compute that his contributionswould buy a monthly annuity of only20 cents, he is apt to think that hehas earned a pension of $10 or $15at least. It is that psychological factorthat you have to take into account.A pension of such a small amount aspeople who are in the system only ashort time can buy, will never be satis-factory to them. It will seem to themthat they are being cheated.28

Congress therefore set an initial minimummonthly benefit of $10 for anyone who hadpaid into the system for at least five years.This meant that early beneficiaries receivedpayments far in excess of any contributions.For example, the very first Social Securityrecipient, Ida Mae Fuller of Vermont, paidjust $22.54 in Social Security taxes, but thelong-lived Mrs. Fuller collected $22,888.92in benefits.29

Second, because the early stages of aPAYGO Social Security system, like the early

stages of a Ponzi scheme, are characterizedby a high ratio of contributors to beneficia-ries, taxes can initially be set at artificiallylow rates.

Current recipients depend on recruiting subsequent recipients who receive lower re-turns. Like a Ponzi scheme, Social Securityparticipants receive payments, not from re-

turns on their own investments, but directlyfrom inflows from subsequent participantsThat means that, as in a Ponzi scheme, thesystem can only continue to provide bene-fits as long as it is able to recruit additional

people to pay into it.Yet, the demographic changes describedabove mean that Social Security has notbeen able to maintain a sufficient numberof taxpayers/contributors. Fewer contribu-tors per beneficiary means that the initiallylow tax rates must rise faster than benefits(see below), resulting in lower rates of returnfor subsequent participants who must paymore in taxes per dollar in benefits than ear-lier participants. As a result, the overall in-ternal rates of return have declined steadily.

In theory, each generations rate of re-turn should be equal to the rate of growthin the wage base covered by the system. Thegrowth of the wage base, in turn, is basedon the growth in the labor force plus thegrowth in real wages.30 As long as the wagebase continues to grow, Social Security cancontinue to yield a positive rate of return.

Calling Social Security a Ponzi Schemethat works, Paul Samuelson summed upthis point:

The beauty of social insurance is thatit is actuarially unsound. Everyonewho reaches retirement age is givenbenefit privileges that far exceed any-thing he has paid inexceed his pay-ments by more than ten times (or fivetimes counting employer payments)!How is it possible? It stems fromthe fact that the national product isgrowing at a compound interest rateand can be expected to do so for as farahead as the eye cannot see. Always

there are more youths than old folksin a growing population. More impor-tant, with real income going up at 3percent per year, the taxable base onwhich benefits rest is always muchgreater than the taxes paid historicallyby the generation now retired. SocialSecurity is squarely based on what has


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Current workers

expect a farpoorer rate ofreturn thanthat receivedby earlierparticipants.

been called the eighth wonder of the

worldcompound interest. A growingnation is the greatest Ponzi game ever con-trived. (Emphasis added).31

Samuelson would be correct if there wereno demographic factors to consider. As longas the wage base supporting Social Securitygrows faster than the number of recipients,the program can continue to pay higherbenefits to those recipients. But the growthin the labor force has slowed dramatically.In 1950, for example, there were 16 workers

paying taxes into the system for every retireereceiving benefits from the program. How-ever, Americans have been living longer andhaving fewer babies. As a result, there arenow just 2.9 workers per beneficiary, and by2020 there will be only two (see Figure 2)32. And real wage growth (especially in wagesbelow the payroll tax cap) has not been near-

ly fast enough to offset this demographic

shift.Thus, as Michael Boskin of Stanford Uni-

versity explained, While the percentage oftransfers in benefits is largest for the firstcohort of retirees (who receive virtually acomplete windfall), the positive intergenera-tional transfers received by retirees . . . [even-tually turns] negative for subsequent retir-ees.33 A worker earning the median wagewho retired in 1984 earned an approximateinternal return of 4 percent on his or hertaxes. In contrast, a similar worker retiring

this year can expect a return of 2.2 percent.If that worker were age 30 this year and plan-ning to retire in 2037, he or she would hopeto earn a return of just 1.5 percent.

Thus, not only can current workers ex-pect a far poorer rate of return than that ex-perienced by earlier participants, but the re-turn they receive is far lower than the return

Figure 2

Demographic Changes and Social Security

Source: William G. Shipman, Retiring with Dignity: Social Security vs. Private Markets, Cato Institute Social

Security Choice Paper no. 2, August 14, 1995, http://www.cato.org/pubs/ssps/ssp2.pdf.


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Social Securitytaxes have been

raised frequentlyto keep the

system financiallyviable.

to private capital investment.In all these aspects, therefore, Social Se-

curity clearly resembles a Ponzi scheme.

A Crucial DistinctionThere is, however, one important dif-

ference between Social Security and Ponzischemes. As the courts have pointed out inregard to Ponzi schemes:

A Ponzi scheme cannot work for-ever. The investor pool is a limitedresource and will eventually run dry.The perpetrator must know that thescheme will eventually collapse as a

result of the inability to attract newinvestors.34

As Mitchell Zuckoff, the Boston University journalism professor who wrote the defini-tive biography of Charles Ponzi, explains,this is not the case with Social Security:

A Ponzi scheme is unsustainablebecause the number of potential inves-tors is eventually exhausted. Thatswhen the last people to participate

are out of luck; the music stops andtheres nowhere to sit. Its true thatSocial Security faces a huge burdenand a significant, long-term financ-ing problemin light of retiring BabyBoomers. . . . But Social Security canbe, and has been, tweaked and modi-fied to reflect changes in the size of thetaxpaying workforce and the numberof beneficiaries. . . . [T]he governmentcould change benefit formulas or takeother steps, like increasing taxes, to

keep the system from failing.35

Unlike the perpetrators of Ponzi schemes,the government can maximize the size ofits investor pool by forcing people to par-ticipate. As an article in Mother Jones put it,crudely but accurately, the difference be-tween Social Security and a Ponzi scheme

is that Social Security is run by the govern-ment, which can print money and tax peo-ple.36

And when shifting demographics limithe number of new participants available

it can increase the contribution from thosewho are available by raising taxes. The So-cial Security Administration itself makes thedistinction this way:

As long as the amount of money com-ing in the front end of the pipe main-tains a rough balance with the moneypaid out, the system can continue for-ever. There is no unsustainable pro-gression driving the mechanism of apay-as-you-go pension system and so

it is not a pyramid or Ponzi scheme.37

Certainly, throughout its history, SocialSecurity taxes have been raised frequently tokeep the system financially viable. The initialSocial Security tax was 2 percent (split be-tween the employer and employee), cappedat $3,000 of earnings. That made for a maxi-mum tax of $60. Since then, as Figure 3shows, the payroll tax rate and the ceiling atwhich wages are subject to the tax have beenraised a combined total of 64 times. Today

the tax is 12.4 percent, capped at $106,800for a maximum tax of $13,234. Even adjust-ing for inflation, that represents more thanan 800 percent increase.

Alternately, to preserve the system, Congress can reduce Social Security benefits. Forexample, in 1993 the Social Security retire-ment age was increased for workers age 45and younger at the time. Since the amountof payments a recipient will receive over alifetime depends in part on how long theycollect benefits, delaying the age at which

they begin to receive those benefits effective-ly reduces the total amount of those bene-fits. Thus, while it is technically true that, asthe Social Security Administration claimsit has never missed a payment, it has paidless than originally promised.

Both tax hikes and benefit reductions re-duce the return that workers can expect on


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their contributions (taxes). As we saw above,

the average 30-year-old will receive barely athird of the return that someone did whoretired in 1985. Most workers will receivereturns far below those provided by privateinvestment. Some will actually receive lessin benefits than they pay into the system,a negative return. Yet, no matter how bad adeal Social Security becomes, workers can-not refuse to participate.

Social Securitys defenders make much ofthe fact that, whereas most Ponzi schemescollapse within months or, at most, a few

years, Social Security has survived for morethan 75 years. As the Social Security Ad-ministrations website proudly notes, The American Social Security system has beenin continuous successful operation since1935. Charles Ponzis scheme lasted barely200 days.38 What goes unsaid, however, isthat Social Security has only been able to

continue its operation and make those pay-

ments by forcing workers to pay higher andhigher taxes.

The Bigger Picture

The back and forth over how to describeSocial Security has obscured a much moreimportant fact: Social Securitys financescontinue to deteriorate. As noted above,Social Security began running a cash-flowdeficit this year, paying out more in benefits

than it takes in through taxes (Figure 4).39In theory, of course, Social Security is

supposed to continue paying benefits bydrawing on the Social Security Trust Funduntil 2036, after which it will be exhaust-ed.40 At that point, by law, Social Securitybenefits will have to be cut by approximately24 percent.41

Figure 3

Payroll Tax Rate and Taxable Maximum Increases

TaxableMaximum($)

PayrollTaxRate(%)

Source: Social Security and Medicare Tax Rates, Social Security Administration, http://www.ssa.gov/oact/progdata/tax, and Contribution and Ben

Base, Social Security Administration, http://www.ssa.gov/oact/cola/cbb.html.


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The SocialSecurity TrustFund is not an

asset that canbe used to pay

benefits.

However, in reality, the Social SecurityTrust Fund is not an asset that can be usedto pay benefits. As the Clinton administra-tions Fiscal Year 2000 Budget explained it:

These [Trust Fund] balances are avail-able to finance future benefit pay-ments and other Trust Fund expen-dituresbut only in a bookkeepingsense. . . . They do not consist of realeconomic assets that can be drawndown in the future to fund bene-fits. Instead, they are claims on theTreasury that, when redeemed, willhave to be financed by raising taxes,borrowing from the public, or reduc-

ing benefits or other expenditures.The existence of large Trust Fundbalances, therefore, does not, by itself,have any impact on the Governmentsability to pay benefits.42

Even if Congress can find a way to re-deem the bonds, the Trust Fund surplus

will be completely exhausted by 2036.43 Atthat point, Social Security will have to relysolely on revenue from the payroll taxbutthat revenue will not be sufficient to pay all

promised benefits. Overall, Social Securityfaces unfunded liabilities of nearly $18.9trillion ($20.8 trillion if the cost of redeem-ing the Trust Fund is included).44 ClearlySocial Security is not sustainable in its cur-rent form. That means that Congress willagain be forced to resort to raising taxesand/or cutting benefits in order to enablethe program to stumble along.

And either the tax increases or benefireductions would need to be significantFor example, to restore Social Security to

solvency would require raising the current12.4 percent Social Security payroll tax to atleast 17.6 percent, a 42 percent increase, orthe equivalent amount of revenue from oth-er taxes.45 (Eliminating the cap on taxableincome for the payroll taxes, one frequentsuggestion, would actually do little for theprograms long-term solvency.46)

Figure 4

Social Security Cash-flow Deficit

Source: Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 20112021, January 2011

$billions


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Social Securityis not a Ponzischeme, becauseCharles Ponzi

didnt have agun.

On the other side of the ledger, as pointedout above, restoring the program to solven-cy would require at least a 24 percent reduc-tion in benefits. Suggested changes includefurther raising the retirement age, trimming

cost-of-living adjustments, means-testing,or changing the wage-price indexing for-mula.

Obviously, there are better and worseways to make these changes. But the largerpoint is that continued tax increases andbenefit cuts will be necessary until the ba-sic structure of Social Security is changedfrom the PAYGO model that so resemblesa Ponzi scheme, to a system where at leastsome of an individuals Social Security taxesare saved for that persons retirement and

invested in real assets.Table 2 shows what that would mean. Un-

like the current Social Security system, eachworking generations contributions actuallywould be saved and would accumulate astime passes. This accumulation, includingthe returns earned through real investment,would then be used to pay that generationsbenefits when they retire. Under a funded

system, there would be no transfer from cur-rent workers to current retirees. Each gen-eration pays for its own retirement.47

In this system, there is a direct link be-tween contributions and benefits. Each gen-

eration receives benefits equal to their con-tribution plus the returns their investmentsearn. And because real investment takesplace and the rate of return on capital invest-ment can be expected to exceed the growthin wages, workers can expect to receive high-er returns than under the current system.

Although from a strictly economic view-point it makes no difference whether invest-ment under such a funded system is doneby the government directly or through per-sonal accounts, one need look no further

than the Troubled Asset Relief Program orthe auto industry bailout to see reasons tobe concerned with government investment.If the goal is to move away from a Ponzi-style PAYGO system to a program based onsavings and investment, a much better ap-proach is to allow younger workers to save atleast a portion of their payroll taxes throughindividual accounts.48

Period 1 Period 2 Period 3 Period 4

Generation 0 Retired Dead Dead Dead

Generation 1Working

contributions

Retired

benefitsDead Dead

Generation 2 UnbornWorking

contributions

Retired

benefitsDead

Generation 3 Unborn UnbornWorking

contributions

Retired

benefits

Generation 4 Unborn Unborn UnbornWorking

contributions

Source: Thomas Siems, Reengineering Social Security for the New Economy, Cato Institute Social Security Paper

no. 22, January 23, 2001.

Table 2

A Funded Social Security System


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The SocialSecurity

program isfacing insolvency

unless it isfundamentally

reformed.

The failure of President George W. Bushsbungled 2005 campaign for personal ac-counts is widely believed to have taken thatidea off the table for the foreseeable future.None of the recent deficit commissions in-

cluded personal accounts in their recom-mendations. However, several new repre-sentatives and senators elected in the 2010mid-term elections appear sympathetic topersonal accounts, meaning that a combi-nation of benefit reductions and personalaccounts remains not only the best policyoption for Social Security reform, but also aviable political option.

Conclusion

So, is Social Security, as currently consti-tuted, a Ponzi scheme? It certainly embodiesmany of the characteristics of one. It makesno investments. Instead, it relies on futurecontributors to pay current recipients, pro- viding a windfall to the first participants,but declining returns to subsequent joiners.It is a system that worked well when demo-graphics were favorable, but is facing insol-vency as the ratio of recipients to contribu-tors increases.

However, unlike Charles Ponzis scheme,Social Security will never go broke as longas the government can force people to paymore taxes and accept fewer benefits. In theend, that is the crucial difference. Social Se-curity is not a Ponzi scheme because CharlesPonzi didnt have a gun.

Yet, Congresss ability to preserve SocialSecurity through higher taxes and lowerbenefits should not distract from the morefundamental problem that the programsPonzi-like structure makes it unable to pay

currently promised levels of benefits withcurrent levels of taxation. In short, the pro-gram is facing insolvency without funda-mental reform. That reform should not justmake young workers pay more and receiveless. Rather, it should remove the Ponzi-likeaspects of the program by allowing youngerworkers to save a portion of their payroll

taxes through privately invested personalaccounts.

A system of personal retirement accountswould be one that clearly is not a Ponzischeme.

Notes1. Rick Perry, Fed Up: Our Fight to Save America

from Washington (New York: Little, Brown & Com-pany, 2010), p. 171.

2. Ibid.

3. Milton Friedman, The Biggest PonzScheme on Earth, Hoover Digest1999 no. 2http://www.hoover.org/publications/hooverdigest/article/7523.

4. Paul Samuelson, Social Security Is a PonziScheme that Works, Newsweek, February 131967, cited by Alex Tabarrok in Is Social Secu-rity a Ponzi Scheme? Marginal Revolution (blog)September 10, 2011, http://marginalrevolutioncom/marginalrevolution/2011/09/is-social-security-a-ponzi-scheme.html.

5. Paul Krugman, What Consensus? BostonReview, January 1997, http://www.bostonreviewnet/BR21.6/krugmann.html.

6. Pensions, Ponzis, and Pyramids, The Economist, September 24, 2011.

7. Laurence J. Kotlikoff, Privatizing Social Se-curity at Home or Abroad,American Economic Review 86, no.2,Papers and Proceedings of the Hundredand Eighth Annual Meeting of the American Economic

Association, January 1996, pp. 36872.

8. Pensions, Ponzis, and Pyramids, The Economist.

9. James Walsh, You Cant Cheat an Honest ManHow Ponzi Schemes and Pyramid Frauds Work . . . andWhy Theyre More Common than Ever(Los AngelesSilver Lake Publishing, 1998), p. 17.

10. Mitchell Zuckoff, Ponzis Scheme: The TruStory of a Financial Legend (New York: RandomHouse, 2006).

11. Social Security Far from a Ponzi Scheme,USA Today, September 11, 2011.

12. Jonathan Bernstein, Catch of the Day, A Plain Blog about Politics (blog), August 17, 2011http://plainblogaboutpolitics.blogspot.com/2011/08/catch-of-day_17.html.


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13. Just 10% Know Government Can SpendSocial Security Money Any Way It Wants, Ras-mussen Reports, October 7, 2011, http://www.rasmussenreports.com/public_content/politics/current_events/social_security_medicare/

just_10_know_government_can_spend_social_security_money_anyway_it_wants.

14. Social Security Benefit Calculators, SocialSecurity Administration, http://www.ssa.gov/oact/anypia/index.html.

15. The 2011 Annual Report of the Board ofTrustees of the Federal Old-Age and SurvivorsInsurance and Federal Disability Insurance TrustFunds, Social Security Board of Trustees, 2011,p. 9, http://www.ssa.gov/oact/TR/2011/tr2011.pdf.

16. Social Security Administration, Your Esti-mated Benefits, https://secure.ssa.gov/apps10/poms/images/SSA7/G-SSA-7005-SM-SI-2.pdf.

17. Social Security Is No Ponzi Scheme, LosAngeles Times, September 11, 2011.

18. The United States Insurance FinancialSolvency Framework, National Association ofInsurance Commissioners, 2010, http://www.naic.org/documents/committees_e_us_solvency_framework.pdf.

19. Consolidated Laws of New York State, Arti-cle 13 Section 3, http://public.leginfo.state.ny.us/LAWSSEAF.cgi?QUERYTYPE=LAWS+&QUERYDATA=$$ISC1303$$@TXISC01303+&LIST=LA

W+&BROWSER=EXPLORER+&TOKEN=01519347+&TARGET=VIEW.

20. Transcript of the 2012 Republican Presi-dential Debate on September 7, 2011, NewYork Times, Sept. 7, 2011, http://www.nytimes.com/2011/09/08/us/politics/08republican-debate-text.html.

21. Thomas Siems, Reengineering Social Secu-rity for the New Economy, Cato Institute SocialSecurity Paper no. 22, January 23, 2001.

22. Congressional Budget Office, The Budgetand Economic Outlook: Fiscal Years 20112021,

January 2011.

23. Budget of the United States Government,Fiscal Year 2012, White House, Table 9.1, http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/hist09z1.xls.

24. Matthew Yglesias, Social Security Is NoMore a Ponzi Scheme than Anything Else that Re-lies on Economic Growth, Think Progress (blog),September 8, 2011. http://thinkprogress.org/yg

lesias/2011/09/08/314095/social-security-is-no-more-a-ponzi-scheme-than-is-anything-else-that-relies-on-future-economic-growth/.

25. Ibid.

26. Martin Feldstein, Private Investment of So-

cial Security: The $10 Trillion Opportunity, CatoInstitute Social Security Paper no. 7, January 31,1997.

27. 363 U.S. 603 (1960).

28. Quoted in Martha Derthick, Policy Makingfor Social Security (Washington: Brookings Institu-tion, 1979), p. 266.

29. Larry DeWitt, Research Note #3: Detailsof Ida May Fullers Payroll Tax Contributions,Social Security Administration, http://www.ssa.gov/history/idapayroll.html.

30. Paul A. Samuelson, An Exact ConsumptionLoan Model of Interest with or without the Con-trivance of Money, Journal of Political Economy 66(1958): 46782.

31. Paul Samuelson, Paul A. Samuelson on So-cial Security,Newsweek, February 13, 1967.

32. The 2011 Annual Report of the Board ofTrustees, p. 53, http://www.ssa.gov/oact/TR/2011/tr2011.pdf.

33. Michael Boskin et al., Social Security: AFinancial Appraisal Across and Within Genera-tions, NBER Working Paper #1891, April 1986,p. 10

34. Merrill v. Abbott (In re Independent ClearingHouse Co.), 77 B.R. 843, 871 (D. Utah 1987).

35. Quoted in Rick Perry Says Social Security isa Ponzi Scheme,PolitFact(blog), September 12,2011.

36. Nick Baumann, A Venn Diagram for RickPerry: Social Security Is Not a Ponzi Scheme,

Mother Jones, August 29, 2011.

37. Larry DeWitt, Research Note #25: Ponzi

Schemes vs. Social Security, Social Security Ad-ministration, http://www.ssa.gov/history/ponzi.htm.

38. Ibid.

39. Congressional Budget Office.

40. The 2011 Annual Report of the Board ofTrustees, p. 9, http://www.ssa.gov/oact/TR/2011/tr2011.pdf.


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41. 2010 Annual Report of the Board of Trust-ees of the Federal Old-Age and Survivors Insur-ance and Federal Disability Insurance TrustFunds, p. 9.

42. Budget of the United States Government,Fiscal Year 2000: Analytical Perspectives, p. 337.

43. This is the discounted present value of So-cial Securitys liabilities over an infinite horizon.The 2011 Annual Report of the Board of Trust-ees, p. 9, http://www.ssa.gov/oact/TR/2011/tr2011.pdf.

44. Ibid., p. 14.

45. Ibid., Table VI.4, OASDI and HI Annual In-come Rates, Cost Rates, and Balances.

46. See Michael Tanner, Keep the Cap: Why aTax Increase Will Not Save Social Security, CatoInstitute Briefing Paper no. 93, June 8, 2005.

47. Thomas Siems, Reengineering Social Secu-rity for the New Economy, Cato Institute Social

Security Paper no. 22, January 23, 2001.

48. A proposal by scholars from the Cato In-stitute that combines the wage-price indexingproposal described above with personal accountsequal to 6.2 percent of wages was scored by ac-tuaries with the Social Security Administration

in 2005 as reducing Social Securitys unfundedliabilities by $6.3 trillion, roughly half of the sys-tems predicted shortfall at that time. If the Catoplan had been adopted in 2005, the system wouldhave begun running surpluses by 2046. Indeedby the end of the 75-year actuarial window, thesystem would have been running surpluses inexcess of $1.8 trillion. Michael Tanner, A BetterDeal at Half the Cost: SSA Scoring of the CatoPlan for Social Security Reform, Cato InstituteBriefing Paper no. 92, April 25, 2005. At the sametime, SSA actuaries concluded that average-wageworkers who were age 45 or younger could expecthigher benefits under the Cato proposal thanSocial Security would otherwise be able to payWhile there is no more current scoring available,there is no reason to presume that savings or ben-efits would be substantially different today.

Social Security, Ponzi Schemes, and the Need for Reform, Cato Policy Analysis No. 689

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