ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
Rick Perry made news a few weeks ago by calling social security a Ponzi scheme. This proposition has been under the microscope ever since and has generated a seemingly unending amount of heat. Actually, we should call it entropy because most of the heat is dysfunctional.
What we find disturbing is that most folks are allowing their political beliefs to shape the debate regardless of economic truth. If they employed logic instead, they would review the definition of a Ponzi scheme and investigate whether the social security system meets those attributes. If one would do that, he or she would conclude that Rick Perry is mostly correct about his observations, though the present-day social security system does have a few features that distinguish it from traditional financial Ponzi schemes.
So what is a Ponzi scheme? A Ponzi scheme, named after the fraudster Charles Ponzi, is a method to steal funds from investors. While variations exist, it generally works like this. The first class of investors is persuaded to buy into an investment plan, attracted usually by above market yields or some guaranteed minimum rate of return. But, this “return” is not a return on capital, nor is it generated from profits earned by the organization. Instead, these investors are paid using funds raised by the fraudster from new investors. This new capital is raised from a second class of investors, who also are enticed by high or guaranteed minimum rates of return. Thus, the return to the first class of investors is a return of capital since it is supplied by the second set of investors. The second set of investors is paid their returns by swaying yet a third group of investors to hand over their money, and the process continues. All the time, the schemer makes money by taking a “commission” on the funds generated, a management fee if you will.
The essential feature of the Ponzi scheme, indeed the defining feature, is the payoff of a promised return to an investor class using funds acquired from a later class of investors. This is exactly how social security works. Retirees are paid benefits not from the actual funds that they put into the system (which were “misappropriated” for other government purposes), but rather from funds supplied by current workers. In turn, these current workers presumably will receive social security benefits when social security taxes are contributed by later workers. This works only as long as the government can con future workers (“new investors”) into funding the social security promise. So, yes, social security is a Ponzi scheme.
One difference between a financial Ponzi scheme and social security is that the latter does not have a schemer who profits by way of commissions or management fees. The analogy is not completely without merit, since these politicians breached their fiduciary responsibility by accessing these social security contributions to fund other projects that no doubt benefited their constituencies and their reelection chances. Instead of being identified as the fraudsters that they are, they are deemed heroes for continuing social security’s promise despite dramatic demographic, economic, and social changes. For this they get re-elected and enjoy the perquisites of continued employment in Washington. So, in a sense, social security does have a collective group of schemers, who ignore the economic reality of an unsustainable pledge. While diffuse, these politicians nevertheless gain at our expense.
Ponzi schemes generally unravel in one of three ways. First, the schemer vanishes, perhaps because he has stolen enough money or he thinks the scheme is close to collapsing. A second way for the scam to end is for existing investors to get cautious or distrustful and opt out. The schemer then has to disburse not only promised returns but also the original investor contribution, thus putting a strain on his plans. Third, a Ponzi scheme may implode when the schemer is unable to provide the promised minimum rates of returns because he or she can no longer attract enough new investors to the scheme. The falling returns cause even more people to be wary of joining, and so it becomes impossible to pay off previous investors.
The politician schemers in the social security scam are not as easily run off as most Ponzi fraudsters. Individually, they leave the system at some point or another, but they almost always are replaced by others who are willing to maintain social security’s status quo by using current period tax revenues to satisfy old promises. Unfortunately, there is no judicial recourse against our elected officials for dumb decisions.
So, what will trigger an end to this financial fraud? The government’s Ponzi scheme will not unravel because the public opts out of the system and demands repayment. The government no longer allows taxpayers to opt out; neither can anybody get a refund. Moreover, today’s rates of return on social security are very low and, in fact, negative for some workers. Even so, today’s workers are forced into the system, even though there is an increasing likelihood that many younger workers will never receive a dime.
Don’t allow the politicians or their shamans trick you—social security will be bankrupt soon (if not so already). In part, this is because retirees are living much longer than when the system was devised in the 1930s. Changing demographics also contribute to the problem. When originally conceived, 16 workers supported each retired person on social security; today only 1.75 workers support a retiree. That today’s social security system is neither social nor secure is not news. So says the President’s Commission to Strengthen Social Security.
As an aside, we find it curious that some of the members of this commission are former members of Congress. What we would like to know is why are they speaking so ominously now, but refused to sound alarms when they were elected officials?
One of the few politicians who got it right was Senator Ernest “Fritz” Hollings (D-South Carolina). He had both the wisdom and the courage to tell whoever would listen the truth about social security. Two decades ago in 1991, he stated:
The truth is that the Social Security Trust Fund has already been stripped bare. There is no trust and no fund.
It is a lot like the S&Ls. The savings and loans had a lot of real estate on the books, a lot of property, a lot of shopping centers, a lot of deposits, and everything else, until you looked inside and found out there was nothing there. The assets were mostly on paper…. Meanwhile, the Social Security cupboard is bare.
If he were alive today, Fritz would not have objected to calling social security a Ponzi scheme. We wish we had more Congressmen like him who are willing to talk turkey instead of just trying to dance the turkey trot. Only when we unmask the social security system for what it really is will there be a chance of reforming it for future generations. Only then can we put a stop to this intergenerational Ponzi scheme.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.
Unless Americans adopt chastity, one does not “run out of” next generations. The scheme is essentially an inter generational compact for the transfer of wealth; one agrees to go away, if paid to do so, so another can enter the labor force and have a job.
While demographics may be inconvenient from time to time, this can be fixed by adjusting immigration.
As for the games pols play with the topic and the money, this is a topic for another day.
America isn’t running out of generations–it is decreasing the number of workers who support the retirees. A drop in this ratio from 16 to 1.75 won’t be fixed too quickly no matter how liberal of an immigration policy we adopt.
In other words, you think that the government will default on its bonds.
That’s the only way in which you can compare the Social Security Trust Fund to “assets … mostly on paper.”
No, we think the government will print money and inflate its way out of debt. See our column “Scarecrows and Aspartame: The Debt Crisis” at http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/219#more-219
Great article Prof. Ketz!
Love the article!!!!!!!
Indeed, right on point when you talk about how social security was robbed for special interest projects.
I don’t understand the focus on SS as opposed to Medicare. It’s true that SS represents an intergenerational transfer that’s not sustainable along the lines it’s been set up. But as these problems go, SS is much easier to fix. Depending on your political persuasion, it can be made solvent indefinitely by increasing the cap on payroll taxes, means testing, or modest benefit reductions (I think the CBO said payouts could continue at 75-80% with no other changes).
None of these things are true for medicare, where the average recipient is now getting close to three times the amount in benefits that they contributed. Medicare has the same demographic issue as pensions, but the increasing cost of care is making the problem an order of magnitude greater in the long run. This worries me a lot more than social security.
Jim, my thinking is that the reason the focus is on Social Security is that Wall Street wants the money not because the system not fixable. Medicare is different because it benefits doctors, hospitals, drug companies, etc. If you pull the plug on Medicare these organizations would take a huge hit in revenue. After all they lobby too. I was shocked to learn that an individual qualifies for Medicare after working only 10 years. Also the amount of the contributions do not matter.
I found the article disappointing. The people that call Social Security a Ponzi scheme are those that also call for the system’s destruction. There is nothing new in Governor Perry’s comments. The Republicans have been calling for the system to be made “optional” (which would destroy it) since the Reagan administration. The Governor is trying to court the favor of certain firms and individuals that would benefit from Social Security’s demise. If Social Security is gone then billions of extra dollars a year would flow into Wall Street from largely unsophisticated investors. These investors would be easy prey for large sophisticated investors who will gladly take their money.
These are not the only two choices. But before we can entertain alternative solutions, we must understand the problem.
The problems with Social Security have been known for at least 25 years. I do not see how calling it a Ponzi scheme provides any further insights into the problem.
Calling it a Ponzi scheme pinpoints the underlying fundamental problem. You can’t fix a problem unless you really and truly know what the problem is. If you want to fix social security, then you have to understand younger generations can support older generations if there are enough people in the younger generation that can generate enough funds to pay for the benefits to the older generation. If one generation is unwilling to have large families, then it should find another business model. Also, you need to understand that both parties have raided social security for a long time and that those raids have left the cupboard bare, just as in a Ponzi scheme.
Perhaps you’re right about calling it a Ponzi scheme doesn’t provide any further insights. …It is a Ponzi scheme, no matter we call it so or not.
I assume eventually there will be some sort of phase out by cohort. So people 55+ will retain full benefits, people 45+ some slightly larger percentage, and so forth all the way down.
Alas, as a 25 year old the prospects don’t look to great for getting back my albeit paltry contributions. I’d almost favor the personal retirement account approach if we would get the employer contribution mandated. I guess the worry there is that people will invest unwisely, not to mention how the asset markets would deal with the sudden influx of liquidity.
Personally, I wonder to what degree the social security trust fund purchases of longer term treasuries contribute to keeping long term rates down.
I could be wrong but I do not think the Social Security Trust Fund purchases any treasuries. My understanding is the government uses the surplus to offset spending in other areas and issues the trust fund an IOU. The trust fund is just a bunch of IOU’s from the federal government with no real assets to back it.
http://www.ssa.gov/oact/progdata/fundFAQ.html#n2
Its a treasury in all but name. An IOU issued by the federal government. Redeemable at face value perhaps, so its a treasury with an embedded call option.
Its a promise from the government to fulfill one of its own future liabilities. This promise will be modified.
Also, government has to borrow less in the market as a result….
In my opinion keeps governments footprint a lot lighter on the long end of the curve
Maybe this is part of the problem also. “The way Social Security benefit amounts are figured, lower-paid workers get a higher return than highly paid workers. For example, lower-paid workers could get a Social Security benefit that equals about 55 percent of their pre-retirement earnings. The average replacement rate for highly paid workers is about 25 percent.” (Source http://ssa.gov/pubs/10045.html).
This leaves me much to think about it. I appreciate that neither of you (Ketz or Catanach) come across as political/partisan (though maybe you have us all fooled!!!). I think as far as tone, language is concerned, most would find your piece here less controversial if you employed the Hyman Minsky notion of “ponzi finance”, which seems economically equivalent to the more traditional and mainstream understanding of a “ponzi scheme.” The problem with saying “ponzi scheme”, as I see it, is that it seems to automatically a criminal intent; A Minskyan “ponzi finance” on the other hand, emphasizes the mechanics (i.e. cash flows not self sustaining, and unable to meet interest/principle payments without external capital), which leaves the question of intent open ended.
So bottomline: perhaps it’d be fairer to say: “Is Social Security Ponzi/Speculatively Financed ?”
I understand this draws less readers, but I think it’s more accurate.
There is a major difference between Social Security and a Ponzi Scheme. Ponzi did not tell his investors that their investment would go to the prior investors. While much of the general public does not read SSA’s Annual Trustees Reports that have come out since the beginning of Social Security, many have, and thus, there was (and is) no hiding of the fact that Social Security is a transfer program. Prior to Social Security, adults took care of their parents, which was essentially a transfer program too. That doesn’t mean it was bad. Social Security replaced much of that. A fully-funded program would have been enormously expensive and would have taken 4 decades to phase in (and the economics of pre-funding that much might be impossible), so politically it had to be a transfer from workers to retirees. So now we don’t have to directly take care of our parents. I asked my folks if they liked Social Security, and they said yes, it was their most important source of income, not because it was their largest check (it wasn’t), but because they knew it would go up with inflation and was guaranteed for life. One of the concerns of policy-makers was that Social Security would break up the elderly from their adult children, which it has done. I asked my parents about that, and they told me that they appreciated the independence they had, and the final years weren’t so bad that they would have given up their independent years. So that’s why politicians for decades have said that Social Security is one of the most successful programs ever. It is almost universally appreciated, and it’s also not that hard to fix, so telling young people that they won’t get anything for what they put in, is incorrect. As someone who worked there, I can promise you, Congress would never pass something like that. It would be the fastest way to losing their job!
Another great read! As usual, you are zeroed in and on target with this one! Thanks.
Ken
I also blogged on this topic, but concluded that while SS has some characteristics of a Ponzi scheme, it cannot truly be considered one because it is legal enforcable and nobody is being “duped.”
You can read it here: http://businesspublicpolicy.com/?p=1985
But we agree on the main issue – that the pay-as-you-go nature of Social Security does share a central characteristic of a Ponzi scheme, in that it pays off one group of “investors” with the contributions of another group.
My bigger concern, however, is that all this debate over what to call it takes us away from the bigger issue: what are we going to do to fix this unsustainable program?