Social Security: Maybe a Ponzi Scheme, Definitely a Bad Investment

09/15/2011 01:20 pm ET | Updated Nov 15, 2011

Rick Perry is getting some heat again this week for referring to the current Social Security system as a Ponzi scheme. Bernie Madoff has taught us that Ponzi schemes can be extremely problematic, so it's important to understand what exactly a Ponzi scheme is and whether Social Security does, in fact, fit the description of such a system.

A Ponzi scheme, by definition, is a form of financial investment that delivers returns to investors by constantly recruiting new investors and distributing the newly invested funds to earlier investors as profit rather than actually turning money into more money. In general, Ponzi schemes eventually collapse because it's virtually impossible to keep recruiting new investors indefinitely at the rate needed to keep the system afloat. In case you're curious, the term Ponzi scheme came about because Charles Ponzi implemented a massive version of one of these things in Boston back in the 1920's.

Social Security, on the other hand, operates by collecting payroll tax revenues from working people and distributing benefits to retired and disabled people. Theoretically, the Social Security System could operate by collecting taxes from working people, holding them in an interest-bearing trust, and giving the principal and interest back when people retire. In practice, however, this is not how Social Security works. Instead, the Social Security administration takes almost all of the money that it collects in a given year and immediately distributes it to beneficiaries. For example, the Social Security Administration took in $781.1 billion and paid out $712.5 billion in 2010. Furthermore, the Administration had $2.6 trillion in reserves in 2010, whereas it would have had a lot more if it were actually acting like a trust fund.

On the down side, the way Social Security is implemented means that there's a lot less in interest-collecting reserves than there could be, which in turn means that the pie of Social Security assets isn't really given a chance to grow. On the other hand, the Social Security assets are just invested in Treasury bonds anyway, so essentially the government is borrowing from and paying interest to itself, making the interest process somewhat moot. In any case, the Social Security Administration insists that it's not running a Ponzi scheme, mainly on the grounds that the system is non-fraudulent and sustainable:

So we could image that at any given time there might be, say, 40 million people receiving benefits at the back end of the pipeline; and as long as we had 40 million people paying taxes in the front end of the pipe, the program could be sustained forever. It does not require a doubling of participants every time a payment is made to a current beneficiary, or a geometric increase in the number of participants. (There does not have to be precisely the same number of workers and beneficiaries at a given time--there just needs to be a fairly stable relationship between the two.) As long as the amount of money coming in the front end of the pipe maintains a rough balance with the money paid out, the system can continue forever. There is no unsustainable progression driving the mechanism of a pay-as-you-go pension system and so it is not a pyramid or Ponzi scheme.

Frankly, whether a Ponzi scheme is by definition unsustainable is somewhat of an uninteresting semantic question. What is more interesting is that the assumption in the argument above doesn't actually hold. First, there is currently an approximate 3 to 1 ratio of payers to beneficiaries in the Social Security system, and the baby boom generation as well as the general increase in life expectancy is serving to push this relationship down to a projected 2 to 1 relationship over the next 30 years. (On average, people are currently expected to live another 18 years if they reach age 65, which means that the government is paying out Social Security benefits over many more years than when the program was introduced.) This won't be a problem if wages grow by 50 percent relative to benefits over the next 30 years, since this would keep the money in and money out in balance. Unfortunately, current economic conditions make such growth highly unlikely. This is why economists and politicians argue that Social Security is unstable and risks running out of money.

It's tempting to think that the Social Security system is at risk of going broke because it's too good of a deal for retirees relative to the money that they put into the system. Apparently, this used to be the case. For example, economist Paul Samuelson wrote glowingly about Social Security back in 1967:

The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in -- exceed his payments by more than ten times (or five times counting employer payments)!

How is it possible? It stems from the fact that the national product is growing at a compound interest rate and can be expected to do so for as far ahead as the eye cannot see. Always there are more youths than old folks in a growing population.

More important, with real income going up at 3% per year, the taxable base on which benefits rest is always much greater than the taxes paid historically by the generation now retired.

Social Security is squarely based on what has been called the eight wonder of the world -- compound interest. A growing nation is the greatest Ponzi game ever contrived.

(See, even he thinks Social Security is a Ponzi scheme, and he won a Nobel Prize.) It must have been pretty good to live back in 1967. Today, on the other hand, we see neither this sort of income growth nor this level of extraordinary benefits to retirees. If Social Security is in fact a transfer system and 3 workers each year fund one beneficiary, retirees are getting a really crappy return on investment. It's like saying "here, pay into this system for 45 or so years so that you can get 3 times as much (inflation-adjusted and wage-adjusted) per year out later for 18 or so years, if you make it to retirement age in the first place. By my calculations, this is a real (again, inflation-adjusted and wage-adjusted) interest rate of 0.5%, which is far less than stellar even if it is sustainable.

Economist Martin Feldstein makes this point even more clear by comparing the return on Social Security investment to that of private investments:

With a 3% payroll deduction, someone with $50,000 of real annual earnings during his working years could accumulate enough to fund an annual payout of about $22,000 after age 67, essentially doubling the current Social Security benefit. That assumes a real rate of return of 5.5%, less than the historic average return on a balanced portfolio of stock and bond mutual funds. Someone who was extremely risk averse could instead choose to put all of his personal retirement account into Treasury Inflation Protected Securities, accumulating enough with a 5% savings rate for an annual payout of about $13,000. Different combinations of savings rates and investment strategies would produce different expected benefits in retirement.

So people can get the same result from a 3% per year fairly conservative investment as they can from a 15.3% payroll tax? Thanks, government! (Granted, Social Security has the advantage of continuing indefinitely until a person dies, but it's still not a great deal.) Ponzi scheme, transfer system, or whatever else you want to call it, Social Security is inefficient because it doesn't provide a real opportunity for assets to grow.