The Great Ponzi Scheme

Rick Perry (and some others) have been making some interesting accusations about the Social Security Insurance program. Namely, that it is a Ponzi scheme. For those unfamiliar, a Ponzi scheme is a type of program in which earlier contributors are paid a return on their investment (normally an unbelievably good return) through the investment monies collected from later contributors.

A Ponzi scheme doesn’t even need to (and normally doesn’t) make a profit from any sort of traditional asset-growth methods (e.g. stocks, bonds, real estate, etc), so long as there are plenty of people continuing to invest. Ponzi schemes always collapse because eventually there are not enough new people investing (normally the person running the scheme takes a whole bunch of money and skips town before this happens).

Since that is the primary income stream for the program, once this stage is reached there is simply no money in the program to pay off the newest contributors. Since each new round of contributors must be larger than the last (in order to have enough money to pay off prior investors), the last round of investors is usually the largest, and ends up losing all or most of their money.

The Social Security Insurance program as enacted in 1935 was not a Ponzi scheme. It was an insurance program. You might ask, “what was it insurance for?” Well, the stated purpose was a kind of retirement insurance, but when you look at the numbers, it was really a kind of age insurance. I don’t know if that’s an already-existing term or if I just coined it, but you’ll see what I mean by that in a moment.

Insurance is a pretty simple concept. You pay a premium that buys you protection against some unwanted event. If you have flood insurance and your home floods, you get some form of compensation for the damage caused. The reason it works is because not everyone collects. This is an important concept, and was present in the original Social Security program. Most people’s houses never flood, so out of all the people paying the premium some small percentage will actually receive compensation. This ensures that the provider is able to make money and the insured are able to collect when a flood occurs.

So, what did this look like for Social Security in 1935? Well, you started paying into the system as soon as you started working, and continued paying into it for the rest of your working years. You became eligible to collect a perpetual payment at age 65 until you died. This might not sound like an insurance program, but if you look at the numbers from 1935 it really was. The average life expectancy for both genders back then was 61.7 years.¹ I’ve been told that’s misleading though, because there was a relatively high infant mortality rate back then which skewed the average life expectancy down (infants who die have not worked and hence have not payed into the system).

So, let’s take the average life expectancy for those who have reached age 20. For 1935, this number turns out to be right around 65.² On average, a person who pays into the program their whole life will not collect. Those that do collect will—on average—only collect for a few years.

This worked for a long time because the numbers at the time meant it worked like an insurance program. Lots of people payed in, and a few collected. Social Security actually made money for many years. However, as life expectancies began to rise, more people started collecting, and those that did collect began collecting for many years longer. Today, the average life expectancy is about 78 years.³ That means the average person on social security today will collect for about 13 years. To put this in perspective, that’s a full 20% of their adult life.

So, the problem with social security is that while life expectancy has gone up, the benefit age has not. This should have been gradually adjusted over the years. You wouldn’t have to change the rules in the middle of someone’s life, you could just make it so that the new (higher) retirement age on the year it’s enacted only applies to those who enter the workforce for the first time that year. Alternatively, you could base each new retirement age tier off of the year a person was born. That way people will go through their entire life knowing what age they can start collecting.

On top of that problem, there’s another one. There’s this big population bubble called the baby boomers. It’s a huge age group and as a whole they are rapidly approaching retirement age. Now, these people payed in their whole life, so their benefits were supposed to be covered, but they’re going to live a whole lot longer than the Social Security program was designed to accommodate. What that means is new people entering the workforce are going to foot the bill for their benefits. Ok, fine. What happens when those people reach retirement age? Their contributions have already been spent.

The system is unsustainable. It’s turned into an enormous Ponzi Scheme. People currently collecting benefits are dependent on new people entering the system, and those people will depend on even more people entering the system when they retire. Eventually it will collapse unless the rules are changed. The math—however inconvenient—doesn’t lie.