Social Security: Defining Ponzi Scheme, President Obama's Candid Comments, Horrific Investment Returns

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Governor Rick Perry of Texas is trying to be the Republican candidate for President 2012. He has recently came under fire and criticism for stating that the Social Security system in this country is a Ponzi scheme. He has been criticized by politicians in both major political parties and a variety of different journalists. The question, therefore, is the following: given the Social Security structure, is it a Ponzi Scheme?

Before answering that question, consider a random set of Ponzi scheme definitions that pop up when you Google “Ponzi scheme:”
 

  1. An investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risks.
  2. A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors, not from any actual profit earned by the organization, but from their own money or money paid by subsequent investors.
  3. A fraudulent investment plan in which the investments of later investors are used to pay earlier investors, giving the appearance that the investments of the initial participants dramatically increase in value in a short amount of time.
  4. A Ponzi scheme is a type of securities fraud where the promoter makes some sort of false or misleading statement about an investment (often including a guaranteed high rate of return) and pays off older investors with newer investor’s monies. Eventually, when the promoter can’t find any new investors, the scheme collapses.
  5. A dishonest and usually illegal business in which many people are persuaded to invest their money and the money of later investors is used to pay the people who invested first.
  6. A form of fraud in which belief in the success of a nonexistent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.

These are different views of what a Ponzi scheme are but most have some common features:
 

  1. Later investors’ money is used to pay earlier investors.
  2. Money is not invested or earned, just shuffled from later investors to early investors.
  3. Dishonesty, fraudulent, misleading, and other negative adjectives are used to describe the process.

Now, what is Social Security:
 

  1. Today’s workers are forced to give up some of their earnings in order to pay today’s retirees, all for a promise that some Americans in the future will be forced to give up their earners to pay today’s workers when they retire. In other words, later investors’, today’s workers, money is used to pay earlier investors, today’s retirees.
  2. Social Security taxes collected today are not placed in an investment account of any type, the money is either paid out directly to today’s retirees and if there is any money left over, it is given to the political class, via the Treasury Department, to fund today’s government functions. In other words, today’s Social Security taxes are not invested, just shuffled from current workers to current retirees.
  3. Citizens are told that there are $2.7 TRILLION worth of money in the Social Security trust fund (it isn’t, see President Obama’s comments below), citizens are told that Social Security is a great retirement plan (it isn’t, see the analysis below), and citizens are given the impression, via their Social Security account statements that they have an account with actual money/wealth in it (they don’t). Sounds misleading, fraudulent, and dishonest to me.

Looks to me that Governor Perry got it more right than wrong when describing the Social Security process as a Ponzi scheme. Such schemes are illegal unless they are run by the government.

Let’s move on to some candid comments made by President Obama. These comments were made in the middle of the debt ceiling negotiations when it looked like the negotiations might fail, resulting in a possible shutdown of the Federal government. In his typical class warfare mode, the President stated that unless he got his way in the debt ceiling negotiations, the government might shutdown and Social Security recipients might not get their checks. Consider the first two paragraphs from an August, 2011 CBS News online article:
 
President Obama on Tuesday said he cannot guarantee that retirees will receive their Social Security checks August 3 if Democrats and Republicans in Washington do not reach an agreement on reducing the deficit in the coming weeks.

“I cannot guarantee that those checks go out on August 3rd if we haven’t resolved this issue. Because there may simply not be the money in the coffers to do it,” Mr. Obama said in an interview with CBS Evening News anchor Scott Pelley, according to excerpts released by CBS News.

But wait a minute!!!! Didn’t Joe Biden recently say that Social Security was solvent with $2.7 TRILLION in the trust fund? Didn’t Harry Reid state a few months ago that he was not going to support any effort on changing Social Security since the trust fund had over $2 TRILLION sitting in it? If that is the case, how come there would be no money to pay out to current retirees almost immediately after the government shut down? Why couldn’t they just temporarily tap that $2.7 TRILLION trust fund?

Why couldn’t they? Because the coffers would be empty. Remember, this is a Ponzi scheme, money coming in from today’s workers (later investors in Ponzi terminology) is immediately paid out to early investors (early investors in Ponzi terminology). That $2.7 TRILLION in the trust fund is nothing more than an accounting entry, it is not a true wealth entry. It consists solely of accounting/paper/near worthless IOUs that the Treasury promised the Social Security process over the decades. That true wealth was paid out to previous retirees or the political class long ago.

The coffers would actually be empty. 2011 is the first year when Social Security will be in a negative cash position, i.e. Social Security taxes collected this year will be less than what is paid out in benefits. Obama appears to understand the fragility of the system.

It is quite worrisome that Biden and Reid do not understand the very basics of the Social Security system because if they do not understand the fragility, they are unlikely to work on fixing the root causes of the crisis before it is too late. Or maybe they do understand the core problems but are just being deceptive about them, hoping that we will not realize how bad the situation really is. In either case, do not expect any comprehensive or elegant solutions to a quickly growing financial crisis.

Finally, it is difficult to agree on what is the biggest Social Security lie, the lie that Social Security is financially solvent and has $2.7 TRILLION worth of wealth lying around waiting for us of us to retire or the lie that the Social Security system is a great retirement option. Earlier this year the Urban Institute published an analysis which showed that on average, the typical American will pay more into the Social Security system than they will receive in retirement checks over their lifetime, hardly a good retirement option.

In 1998, the Heritage Foundation did another analysis which showed that an average American couple living earning an average American household income would get $430,000 in Social Security benefits in their lifetimes. However, if they had been allowed to keep their money and invest it in a tax deferred investment account, investing half of their funds in T-Bills and half in a stocks, they would have $975,000 available at retirement, more than twice what they could expect from Social Security. Another verification that maybe Social Security is not a great investment vehicle.

As a numbers person, I decided to check out these two analyses relative to my own situation. I went to my own Social Security “account” statement and built the following simple model:
 

  • From my account statement I could see how much money I had donated to the system each year during my working life.
  • I doubled that amount to account for the money also sent to the Social Security Administration in my name by my employers.
  • I assumed that I was able to keep both pots of money and place them in a tax deferred IRA-like account that was invested in an S&P 500 index mutual fund.
  • I found the annual investment returns of the S&P each year over the past forty four years, the length of time I have been working and being taxed by Social Security.
  • I assumed that going forward from 2011 that I moved all of the accumulated investments and contributions to a conservative investment fund earning 4% return a year, a typical investment strategy as you get closer to retirement.
  • When I turned 65 I would start drawing down money out of the account for living purposes.

The results are pretty depressing and stark:
 

  • If I withdrew twice the amount of money from this tax deferred account that Social Security says it will pay me at age 65, I would never deplete the account, regardless of how long I lived.
  • If I withdrew three times the amount of money from this tax deferred account that Social Security says it will pay me at age 65, I would deplete the account when I reached the age of 97, assuming I live that long.
  • As a further example, if I had invested all of that money in Treasury Bills over the past forty four years, I could withdrawal three times the amount of money from that account until I was 94 years old.

Another positive asset of this approach, if it had ever become reality, was that I would control all of my assets. I would not be subject to the whims and changes that the political class can legally impose on Social Security. Yes, even though Social Security can tell you what you are likely to get back form them when you retire, that can be changed at anytime by Congress, the President, and the political class, just another negative of this process.

Thus, no matter how or who cuts the data and what type of analysis is done, it is pretty apparent to anyone with an understanding of basic math that this is a lousy retirement plan. Unfortunately, most people in the Washington political class apparently do not have a basic understanding of math.

No matter how interesting it is to do these what-if analyses, we are stuck with today’s reality. This reality includes a dwindling number of workers to support a growing number of retirees, a cash flow situation that is negative and contributing to our national debt, and a political class that is either in denial or in ignorance when it comes to understanding the Social Security problems and processes.
 

Which leaves us with the need to fix the current system using the three steps:

  1. Gradually raise the retirement age to 70 years to account for the changing demographics and provide some financial breathing room to the financials, but include a hardship exemption for Americans that cannot afford to wait until age 70.
  2. Prohibit Social Security retirement checks to Americans with a net worth value over $3 million since they really do not need a monthly Social Security check to live comfortably.
  3. Uncap the maximum amount of income that can be subjected to Social Security tax, reduce the Social Security tax rate, and expand the types of income that can be subjected to the tax in order to have every American pay the same percentage of their incomes into the process.

The first step in fixing the problem is recognizing reality: this is a Ponzi scheme that is rapidly approaching its collapse point, it does not have TRILLIONs of dollars of wealth sitting around waiting to be paid out to future retirees, the system is in a negative cash flow situation today, and it is really a horrific retirement investment option.

Until our political class recognizes this reality and has the courage to tell us the truth and implement the necessary changes, we can be sure that Social Security will face the same fate of every other Ponzi scheme in history: collapse.
 

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