The Breakdown | Explaining Southern California's economy

Econ 474: Is Social Security a Ponzi scheme?

If you followed my live-econoblogging of last night's Republican debate at the Reagan Library, you know that Gov. Rick Perry of Texas refused to back down on his assertion that Social Security is a "Ponzi scheme." Bear in mind that Perry has been on the record with this position for a while, but most of the post-debate punditry focused on whether it was politically wise for him to so stridently restate the view. 

Perry was clearly playing to his base — and maybe even providing some cover for his lack of a comprehensive economic plan compared to Mitt Romney, who laid out his jobs plan in detail prior to the debate. Regardless, he's certainly not the first person to call Social Security a Ponzi scheme, but he's the latest and arguably most prominent figure to completely misrepresent how Social Security actually works.

It's really not that complicated

It's really pretty simple. a Ponzi scheme is a criminal undertaking that's designed to enable the perpetrator to eventually take the money and run. Just ask Bernie Madoff, who made the critical mistake of not running when the running was good. Social Security, on the other hand, has enpowered working Americans to permit generations of other working Americans to retire and enjoy old age without falling into poverty.

The Social Security Administration's historian (that's right — Social Security is such a pillar of American economic life that we have an official historian to chronicle its legacy) has provided a comprehensive explanation of both a Ponzi scheme, which inevitably fails, and Social Security, which has been around since it was implemented in 1935:

The problem with Ponzi's investment scheme is that it is difficult to sustain this game very long because to continue paying the promised profits to early investors you need an ever-larger pool of later investors. The idea behind this type of swindle is that the con-man collects his money from his second or third round of investors and then beats it out of town before anyone else comes around to collect. These schemes typically only last weeks, or months at most.

And here's why Social Security is different:

[I]t would be most accurate to describe Social Security as a transfer payment--transferring income from the generation of workers to the generation of retirees--with the promise that when current workers retiree, there will be another generation of workers behind them who will be the source of their Social Security retirement payments. So you could say that Social Security is a transfer payment, but it is not a pyramid [or Ponzi] scheme.

I'm not one to quote from Wikipedia, but this language actually captures the essence of why Social Security can't be labeled a Ponzi scheme:

One criticism of the analogy is that while Ponzi schemes and Social Security have similar structures (in particular, a sustainability problem when the number of new people paying in is declining), they have different transparencies. In a Ponzi scheme the fact there is no return generating mechanism beyond just contributions from new entrants is obscured whereas Social Security payouts have always been openly underwritten by incoming tax revenue. No true Ponzi scheme can be sustained indefinitely, whereas Social Security's benefits can always be sustained by raising additional taxes.

The system is actually in surplus

Additionally, the money in the Social Security trust fund (the surplus that remains after benefits have gone out) isn't invested in anything at all risky. It's not like a pension fund, for example. It's in U.S. Treasuries. 

The problem with Social Security is that it's not a perfect "pay-as-you-go" system. To borrow the Social Security Administration's own numbers, there may theoretically not be 40 million drawing on the funds that 40 million people are paying in. We haven't hit that mark yet, however, but a trend has become glaringly apparent in recent years. In the beginning of the program, for instance, there were far more workers paying in that there were beneficiaries taking out. But that ratio has been greatly reduced, from 42:1 in 1945 to just under 3:1 in 2010

Panic sets in when you realize that the retiring Baby Boom generation could knock that ratio down even lower, forcing the government to access the trust fund to continue paying out all benefits. Please note here that we haven't even yet hit the 1:1 ratio for a pay-as-you-go-with-zero-surplus model the SSA uses for its own "We're not a Ponzi scheme" example I've referenced above.  

Now, you can talk about how benefits aren't going to be enough to properly fund a retirement and that's why people should be able to invest a portion of the benefits they've "banked" (which they actually haven't — the only thing they could invest at greater risk than treasuries is their slice of the trust fund, and they don't have individualk access to this pool of money). But benefits are already adjusted for inflation, so that's really unnecessary. What retirees do need to consider is thinking of Social Security as the basis for retirement, not the whole tamale.

But there are numerous ways to sustain the trust fund, from raising the cap on taxed income to increasing the core tax itself to increasing the retirement age to decreasing benefits. The American Prospect lays many of them all out (and yes, that left-leaning publication doesn't think Social Security is either in crisis or a Ponzi scheme). 

These problems are being addressed, albeit slowly. But unlike in a Ponzi scheme, no one is trying to take the money and run.

Photo: Joe Raedle/Getty Images