Perry Is Right: Social Security Is a Lot Like a Ponzi Scheme

FDR wasn't Bernie Madoff, but his program's severe structural flaws cause it to resemble that of a fraudulent hedge fund

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Now that it is beginning to look like Texas Gov. Rick Perry has a serious shot at nabbing the Republican presidential nomination, his critics have begun dissecting his political views. One particularly controversial one is his claim that Social Security is a Ponzi scheme. As you might guess, progressive groups are particularly disturbed by this assertion, since it implies that he is against entitlements. Although he may be technically wrong, he's basically right.

Why Social Security Is Like a Ponzi Scheme

Zaid Jilani at Think Progress argues that Perry doesn't know what he's talking about:

A Ponzi scheme is an economic arrangement where the money paid into the system by later entrants is paid right back out as benefits to earlier entrants. None of these social insurance programs that Perry mentioned fit this definition. They benefit those who pay into them with guaranteed benefits.

Wait -- what? Social Security fits that precise definition. It was created during the Great Depression by President Franklin D. Roosevelt. Retirees began receiving benefits immediately, without having paid into the program themselves. Those benefits were paid by taxing current workers. So, in fact, Social Security is technically identical to the definition of a Ponzi scheme that Jilani provides.

And Those Guaranteed Benefits?

But what about those "guaranteed benefits"? Don't those make a difference? Well, let's think about this. Imagine if an investment advisor came to you and said:

"Hi there! I want to sell you a retirement vehicle for which you will be provided a guaranteed benefit of x dollars per year after the age of 65. But the money you contribute will be paid to current beneficiaries, while your money will be paid by future beneficiaries. If there's ever a shortfall, we'll just borrow money from China in order to keep the guaranteed benefits coming -- or force future contributors to provide more money. Alternatively, we might increase the age at which you'll receive benefits. And we might even think about means testing your benefit."

All of those supposed "guaranteed benefits" sure come with a lot of caveats, don't they? Is it even fair to call those benefits guaranteed? For all we know, the U.S. could continue to run into deficit problems for the next few decades and could feel compelled to do away with Social Security altogether. We have no real guarantee that political whims won't change.

So when provided that deal would you say, "That sounds great! Sign me up!"? I know I wouldn't. Of course, this is precisely the way Social Security works, and it's mandatory, so we've got no choice but to comply.

Other Defenses

There are several other arguments for why Social Security actually isn't like a Ponzi scheme. They're all weak.

No One Is Being Misled

First, don't people know exactly what they're getting into with Social Security? There's no shady investment manager promising lucrative returns, like we saw with Bernie Madoff's Ponzi scheme, for example.

But aren't Americans being somewhat misled by Social Security? If the benefits age rises, then people were misled. If the government decides to means test benefits, then Americans were misled. Just because, deep down, we might realize that Social Security will be a pretty raw deal for future generations doesn't mean it's suddenly far preferable to a regular old Ponzi scheme.

Not Doomed to Fail

Next, in an alternate world Social Security might have been just fine. If population growth had continued to increase forever, then it would never have run into money problems, and it all would have been sustainable.

True, but the same could be said of a Ponzi scheme. It's only when investor growth slows that a problem arises. Of course, this is exactly the problem that Social Security faces: population growth slowed, and now it's running out of money.

Social Security Is the Moral Opposite of a Ponzi Scheme

But what if Madoff's heart was in the right place? What if he had designed his Ponzi scheme specifically for non-profit firms? They contribute and that money was provided to other non-profit beneficiaries.

Would that have made it any less of a Ponzi scheme? The idea that Social Security is somehow exempt from any criticism because it's meant to help people is just bizarre.

Not Intentional Fraud

This is sort of connected to the claim that no one has been misled, but is more technical. In a strictly legal sense, Social Security cannot be considered fraudulent, because it has worked just as it was supposed to.

Okay, so FDR was bad at math and/or predicting the future. Does that make us feel any better about the potential flaws created by a system that pays current retirees based on the contributions of current workers? It shouldn't. It's still a bad system.

It's Just Like Insurance

A friend of mine who I was just discussing this question with asserts that Social Security is just like life insurance. Insurance companies may pay out current benefits based on the premiums paid by current contributors. The problem, he says, is just that the government is pretty bad at actuarial math and screwed things up.

I have two rebuttals. First, from the very start, Social Security was different than a legitimate insurance fund. Imagine if a company said, "We're starting this insurance fund and one group of people don't have to pay into it, but will begin receiving payments immediately, based on the contributions of future beneficiaries." Does that sound like a sound investment to you? It doesn't to me, which is why life insurance companies aren't run that way. It may happen that a small number of beneficiaries will receive payments soon, if they die unexpectedly. But first, they already paid some premium. And second, this isn't a large group who was exempted from paying from the start: they're an exception to the rule.

Second, even if such a poorly-designed insurance fund were to succeed, that doesn't mean it was a sound entity. An obviously much better system would be to create accounts for each investor, where each person's eventual benefit is provided by the money contributed his or her account over the years, possibly magnified a little if invested conservatively. This would not be subject to population growth rising and falling. You can even provide a defined benefit, if your assumptions are sufficiently conservative.

Of Course, Social Security Didn't Have To Be Structured This Way

Please understand: this isn't an argument against the existence of any sort of government pension for retirees. If FDR had structured Social Security differently, it wouldn't have been Ponzi-like at all. For example, he could have begun paying the elderly immediately through deficit spending or higher general-purpose federal taxes, but then set aside the money paid into the Social Security fund by current contributors for when they retire. Obviously, this would have created a rather large deficit or much higher tax rates for about a generation. But that's what would have been necessary to ensure that Social Security would have been a stable program, if he was adamant about retirees receiving money immediately without having contributed. Population growth would not have mattered.

Image: FDR signs the Social Security Act, Wikimedia Commons