Pension and Ponzi Schemes
In the US, there is a heated debate about America’s government pension scheme Social Security. The Republican frontrunner for President Rick Perry has called it a ‘Ponzi scheme’, for which he was derided by the previous Republican frontrunner Mitt Romney. Here’s the question: is Rick Perry right. Is social security a Ponzi scheme?
Here’s my take.
Ponzi Schemes
Ponzi schemes are frauds. Here’s how the American markets regulator Securities and Exchange Commission defines Ponzi schemes:
What is a Ponzi scheme?
A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.
Why do Ponzi schemes collapse?
With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.
How did Ponzi schemes get their name?
The schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors that he could provide a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds to pay off earlier investors.
At heart here is trust. A fiduciary, someone who has a “legal or ethical relationship of confidence or trust regarding the management of money or property”, gains the trust as an agent acting on behalf of someone else. He then violates that trust willingly and intentionally by making promises that he knows he cannot keep. Further, the fiduciary, realising that his deception will be found out, is forced to either escalate or desist. The Ponzi scheme aspect comes when the fiduciary recommits to the initial fraud by pulling in more people to pay off the first trusting souls, escalating the deception.
So what happens is you trust someone, they violate that trust knowingly and intentionally. And cover this up by doing the same to others. As in all crimes, it is the cover up that is fatal.
Pensions
In the old days, when economic growth was robust in North America and Western Europe. Defined benefit pension plans were the norm. The thinking at the time was that the corporation employing an individual and/or an individual’s government had an obligation to allow that individual to live a decent lifestyle after he stopped working. The thinking was, “If we can’t protect our citizens from the poverty we have worked centuries to overcome, what is the point of our being a rich nation, then?” The problem was that the economic growth and demographic expectations embedded into the promises companies and governments made in the 1950s, 1960s and 1970s proved wrong.
Here’s an example for you on final salary pension schemes from the British press just in the past day:
The deficit of the 6,533 final-salary schemes in the private sector had been £67.3bn at the end of July and £73.8bn in August last year.
There were 5,012 schemes in deficit and 1,521 schemes in surplus, the PPF said.
The schemes were hit by the falling value of shares in August, with the FTSE 100 having fallen by 7.5%.
This is the reason these final salary pension schemes are no longer the norm. The reality is that private sector pension schemes are built around 5-7% nominal GDP growth that includes 2-3% inflation and 3-4% real GDP growth. We are about to enter a period of low nominal GDP growth due to an overhang of private sector debts which will restrain consumption, consumer demand and economic growth. Nominal GDP growth of 3-5% is a more realistic upside scenario.
SocGen’s Andrew Lapthorne had it right when he wrote:
- Storing up problems for the next generation seems to be a recurring global theme these days. One such problem is the overly optimistic returns expectations embedded within many corporate and state pension funds. We estimate US pension funds are factoring in a nominal 9% equity return in the long-term. In the UK it is some 100bp lower.
- How realistic are these expectations? Well if history repeats itself, following such a poor 10-year return period as we’ve experienced, on average the S&P 500 has delivered 11% real over the next ten years. However, given the sharp rebound in equity prices since March 2009, half of that gain is already behind us. An analysis of Shiller PEs and future returns also indicates average real returns of just 1.7% going forward.
His conclusion: US Pension Funds are implicitly betting on Dow 40,000.
It is these same implicit bets of economic, industry or company growth during the inflationary 1970s which ballooned the pension costs of US manufacturing and airline industries and contributed to their collective bankruptcy. Companies and unions alike agreed to kick the can down the road by making this bet in order to allow employees to get through the inflation of that period. In the end, however, these bets went bust and so did the companies making them – years after the executives who made those fateful decisions had retired, of course.
In the public sector, gold-plated pensions in some states will consume 25-30% or more of tax revenues in future. That will mean higher taxes or reduced services. Voters will not go for that. In the next downturn, this issue will come to a head for municipalities and states, voters and muni bond holders alike.
Social Security
Is it any different for federal government pension schemes in Europe and North America like social security? I say no.
Now if I were a political candidate, I don’t care how much I wanted to pander to the anti-government crowd. I would realise that attacking social security by calling it a ‘Ponzi scheme’ is setting me up for a rumble with retirees. And retirees vote. You can qualify this thing all you want, about how you mean reform will only happen for people below 50; it’s not going to work politically. What people will hear is “I’m running for office telling you I promise to help government renege on its promises to you.” Do you think that’s a winning pledge?
This is why Social Security and Medicare are third-rail political subjects. I don’t believe Social Security is a Ponzi Scheme, no. Government did not intentionally and wilfully make promises that it could not keep. The demographics and perpetual growth assumptions have simply caught up with us all. This is true for the private sector as much as it is for the public sector.
But I do believe that it is unsustainable for the US to keep the same promise to seniors today as it had 6 or 7 decades ago when life expectancy was much shorter. In real terms, retirees today have put in less in present value terms than they will receive in benefits. That is why there are large unfunded liabilities for social security.
There is no way around this except through cuts, tax increases, or deficits. And the deficits are the kind of thing that will cause inflation in an economy operating at full employment. You can print all the money you want to fulfill these promises. The bottom line is people want to be able to consume real resources in retirement not dollar bills; unless you commit greater amounts of society’s real and financial resources to retirees, that can’t happen. Put simply, future generations must pay more – that is unless you think we can grow our way out of the problem, which is a legitimate view some hold. For those of us under 50, sorry we have lost the retirement lottery.
Solution?
The usual solution is to kick the can down the road. The progressive view that social security should not be touched implicitly says either we will grow our way out of this or we should accept the increase in resources allocated to retirees as part of the benefits of being in an advanced society. Tell that to young people straight out and they will reject this. The conservative view that we should privatise social security so that Wall Street can take those funds on the same boondoggle they have taken stocks and housing is insanity. With the deficit hawks on the warpath, it makes sense to me to reduce the deficits associated with social security. You could raise taxes, reduce benefits, reduce coverage, or delay benefits. I say delay benefits by raising the age of retirement to 67 and eventually even to 70 for those under 50.
If you raise the retirement age enough, you would then be able to increase the Social Security benefits you pay out. Of course, you would have to police age discrimination laws assiduously (see this recent example from Germany) and deal with how demographics play out negatively for minorities, manual laborers and lower-income people. The problem with entitlements is not social security but the rise in healthcare cost; and this is inextricably linked to America’s aging society and the outsized healthcare spending in America’s private sector. See “The correlation between healthcare spending and life expectancy.” America needs a better social safety net. So it is perfectly reasonable to make one available while lowering the deficit by reducing how regressive FICA taxes are while also raising the age limit.
Here’s something to think about as I put it early in 2009:
As I see this downturn lasting a very long time, even this kind of thinking will not go far enough in dealing with the economic insecurity to which we have all been exposed. Going forward, I see the whole idea of defined contribution coming under attack as people realize that huge financial burdens have been transferred from corporations to individuals. This conversation will take on a populist tone because I think many will notice that the owners of capital have become much richer over the preceding generation, while ordinary workers have not. With the illusion of wealth now gone as paper wealth declines, many will come to realize that we have just seen a massive transfer of risk.
Will this result in increased forced savings? Perhaps. After all, It is now evident to all that defined contribution pension plans work in good times but are woefully inadequate in bad times. I see this as the basis for some fundamental change. With that in mind, I say that if we are to follow the New Deal in any regard, it should be to increase the economic security of average citizens in a time of crisis. When politicians talk about change, this is where change must begin.
Nice little synopsis. I’d actually argue that politicians have in fact willingly and intentionally avoided dealing with entitlements to a point that their actions result in our current predicament. Being the “third rail of politics” does not absolve a fiduciary of their responsibilities. The same conclusion could be drawn for FNM and Freddie. In laymen’s terms, idiocy and sloth are no excuse for economic thievery…which is in fact what entitlements are when wantonly applied.
Fred, I don’t agree. Is that your anti-government bias talking? The private sector, companies AND HOUSEHOLDS are in exactly the same boat of overestimating growth in the economy, profits, and wages. It’s called the asset-based economy. The reality is the US has been living beyond its means via private sector debt-fuelled growth for some time. The right way to look at this is that all of us have overestimated the NPV of future growth and now the day of reckoning is at hand. We can kick the can and make things worse down the line or deal with it and get it behind us.
EH wrote: “people want to be able to consume real resources in retirement…unless you commit greater amounts of society’s real and financial resources to retirees, that can’t happen. Put simply, future generations must pay more”
Without mentioning the size of the problem, you make it sound as if SS needs massive changes to remain viable. That is not true. Slight tweaks will fix it for the rest of this century.
“Social Security has a small long-term funding shortfall. It can be fixed easily. The CBO recently estimated that Social Security has a long-term cumulative deficit of 0.6% of GDP, and the table below lists 30 options for fixing this. All you have to do is pick some combination of options that adds up to 0.6% and you’re done.” Source: https://motherjones.com/kevin-drum/2011/09/some-gutsy-talk-social-security
Now Medicare is another story, but as Dean Baker keeps writing, if we had the same overall health care costs as the rest of the developed world, the federal budget would be running a large surplus.
I agree with you here so I am not really making it sound like you need massive changes in Social Security. After all, I did say “The problem with entitlements is not social security but the rise in healthcare cost; and this is inextricably linked to America’s aging society and the outsized healthcare spending in America’s private sector. See “The correlation between healthcare spending and life expectancy.”” Did I not?
I disagree with the statement that social security taxes are regressive. When you consider the fact that social security contributions are taxed when confiscated, and taxed again upon retirement (if you make too much money) or eliminated because you work during retirement, the program is hardly regressive. This is the liberal’s way of trying to increase taxes.
What does that mean, “This is the liberal’s way of trying to increase taxes.” And to whom are you referring? It sounds like ideological claptrap to me.
As I said in the article: “There is no way around this except through cuts, tax increases, or deficits”. I have said I would much rather make cuts via delaying benefits for those under 50. But you could also make cuts in other ways, raise taxes or engage in deficit spending. There’s nothing ‘liberal’ about this. It’s a recitation of the options available.
FWIW, as the Social Security Special Treasuries mature, there will be no net increase in government debt. Just a swap of Special Treasuries for Regular Treasuries and a release of cash to seniors (who were the ones with excess withholding for over 30 years).
They will probably use that cash to pay increased medical insurance due to Medicare being restructured between now and then. So, the financialized medical sector gets a significant share of the retirement income. What are you complaining about?
For those in their 40s, note that if the economy’s real productivity grows at 1% a year, that is an additional 20% to 25% output for the same labor input by the time you retire. What will you do with all that free time?
Which means the economy can tolerate all those useless seniors receiving pensions, unless you believe all the economy’s productivity should go elsewhere.
There’s a lot of morality talk about how American consumers overbinged on credit but that makes no sense; they were rationally reacting to price mechanisms and increases in the credit supply.
America is a nation whose growth in recent decades has been predicated on a model of consumption. From a nation that used to save to invest, we now borrow to consume.
Instead of indicting the people whose financial frauds wrecked the economy, this administration put them in charge of it. He never explained that decision to the public — a failure in storytelling as extraordinary as the failure in judgment behind it. Risk avoidant corporate strategies, on a large scale, have sought to use government access and de-regulation to shield themselves from risk.
Given the activities U.S. banks have been involved in during the past two decades, and the actions they’ve taken, we’d be justified in labeling these institutions as “criminal enterprises.”
It’s not about morality; it is the reality. Americans lived beyond their means and now they have to tighten their belts. It is not that they binged on credit, but rather as you say were provided an excess of credit.
Here’s how I see it. Real hourly earnings peaked in 1973 in the US (https://pro.creditwritedowns.com/2008/06/chart-of-day-real-hourly-earnings.html). Since then, ordinary Americans have been forced to use various methods to increase household incomes. Decent health, benefit and retirement packages for unionized employees helped in the 1970s. The addition of women to the labor force helped starting in the 1970s too. But the biggest help was credit and deregulation. The financial services industry – and running up huge amounts of credit to households (and companies) – turned into the big money maker for the US. In Germany, by contrast.the financial services industry was geared to medium sized companies (which also binged on credit). The addictive household credit industry with its Ninja loans and incessant credit card applications just is not there. In fact, in many places, credit cards are not accepted. This isn’t true in the UK or the US where credit cards are par for the course. The bottom line is that government got in bed with the deregulated financial services industry and permitted them to cajole cash-strapped consumers to run up their credit in order to keep their heads above water.
Obviously, while you complain about moralising on the credit habits of Americans, you are moralising about frauds which supplied that credit and wrecked the economy getting off scot-free. But I agree that it is unconscionable that these frauds have not been prosecuted.
The discussions (I have read) using numbers in an unbiased way conclude Social Security (SS) is funded through 2025. And if the payroll tax ceiling is lifted, it’s funded for 75 years.
Here’s one such discussion. It’s from an admittedly progressive site but relies on the OMB and SS Trust for assumptions and data. https://www.cbpp.org/cms/index.cfm?fa=view&id=3104
I’m retired and have a decent pension augmented by SS. My former co-workers will no longer get a pension. As EH wrote pensions are increasingly difficult for employers but they are also next to impossible for employees with 401s. SS will be far important for the growing number of Americans who will retire without pensions. SS decisions should be made within the context of the relative importance of government funded programs.
Well said Douglas. The fix to SS is relatively easy. Politically, the choices have to be made between raising taxes, cutting benefits and running deficits. In my view the easiest thing to do would be to delay benefits (i.e. cut the NPV of benefits) enough to not just get the funding squared away for the 75 years but enough to increase benefits. That is a sort of quid pro quo to future retirees telling them that government remains committed to making sure Americans have an adequate social safety net.. The toughest political issue will be with the payroll tax, the exemption of which has not kept up with inflation because it runs into taxation and fairness issues which are inherently philosophical and political more than economic.
You laid the foundation and background well here Ed. thank you.
However you realize that federal expenditures do NOT rely on federal receipts, so why are you saying Social Security is unsustainable or we over-estimating things?
Please tell me why we can’t just pay our seniors $2,000 a month for example that has a phase-out mechanism built into it if they have other streams of earned or passive income for example? And that’s assuming no FICA at all and no federal revenues for SS…and for all practical purposes we WILL have federal revenues for SS anyway, so there you go. Why can’t this happen? What exactly is unsustainable here?
Why is this all about “responsibility” and “failed economic predictions” when we all know that the US government cannot go broke? Are we concerned grandma and grandpa are going to “inflate” the US economy by paying rent, going to the casino once in a while, and treating their grandkids to ice cream sundaes? I mean seriously the type of “argument” you frame here about “responsibility” and “reality” is quite disconcerting coming from someone like yourself who already knows how federal expenditure works. I’d expect such false “rational” thinking from someone like Obama and or course Perry and clan but I wouldn’t expect it coming from so well read and studied a man as yourself.
Please explain what I’m missing here as I believe this topic one of the MOST criminal accusations we will see in the 21st century….an “accounting rationalization” to leave seniors poor, homeless, and helpless. Dear Lord WTF is going on here?!?!! Our government can’t even go broke and we’re already ready to throw seniors out the door. God rest the Souls of such sacrificial heathens!!!
Please help me understand what I’m missing here or please update your premise and solutions asap and write another article.
Thank you and most respectfully and kindly,
Mario T.
The US can’t go broke.. Expenditure by a sovereign government is independent from taxing or borrowing. Nevertheless, the sustainability of any government program is first and foremost about the opportunity cost of real resource allocation and not about going broke. As I said:
“unless you commit greater amounts of society’s real and financial resources to retirees, that can’t happen. Put simply, future generations must pay more – that is unless you think we can grow our way out of the problem”
I am ideologically opposed to using even more real resources of the economy for retirement. Do we want people to relinquish less in NPV terms today than they will receive tomorrow for retirement and do we think that is something we can commit to? I say no, without productivity gains, it means ever more real resources going to support seniors. Moreover, to talk about social security as if it is divorced from the payroll tax makes no sense whatsoever. From the very beginning it was seen as a federal government scheme that would be covered via specific payments appropriated to it like any other pension plan. Social security is not a general government program. As FDR said when signing the provision in 1935:
“This social security measure gives at least some protection to thirty millions of our citizens who will reap direct benefits through unemployment compensation, through old-age pensions and through increased services for the protection of children and the prevention of ill health.”
Read more at the American Presidency Project: http://www.presidency.ucsb.edu https://www.presidency.ucsb.edu/ws/index.php?pid=14916&st=social+security&st1=#ixzz1XxMNJa7G
Even if we were to ‘pay for it’ by trying to match the NPV of payments to benefits received, the problem of real resource allocation will still be there and that is the point, a political philosophical one, not an economic one: do we want to use more and more resources to fulfill the retirement wants of our population? We ask the same question about retirement and leisure. in the US 2 weeks is mandated for vacation for full time employees. I would like to see a 4-week paid vacation mandate. But, again, this goes to politics more than economics.
“without productivity gains, it means ever more real resources going to support seniors.”
what’s wrong with that? And have you considered how technology has effected productivity in relation to populations?
As I see it demand runs our economy. The baby boomers are a huge part, if not THE part, that carried our economic growth the past 30-50 years. So if they are still spending on health care, food, clothing, vacations, services, etc. in their retirement years then they are still contributing to our economy. And who is going to be PROVIDING these seniors with those goods and services? The rest of the population. I don’t get the issue at all that you think is going to be happening. Do you think there won’t be enough people around to service the baby boomers? Trust me, if there’s demand, the supply will be there.
The only difference is the tables have turned. It used to be the baby boomers were serving and being served, but as retirement comes around they are served and the younger generations are serving them. What pray tell is wrong with that?
“to talk about social security as if it is divorced from the payroll tax makes no sense whatsoever.”
yes it does, b/c you’ve already admitted and know full well that the US cannot go broke and that federal expenditures have nothing to do with federal receipts. The FICA tax is simply a legacy system that no longer applies to our current economy anymore. The only thing the FICA tax is doing operationally is curbing inflation by that much in our economy. It is not and does not “fund” Social Security unless we legislate it that way. You’re statement is no more accurate than a statement about the legitimacy of the debt ceiling I’m sorry to say.
Social Security doesn’t need to stay in the same form that it was created by Roosevelt. We are in a different economy today and that means we need to adjust our policies appropriately. And if social security did change over and taxpayers weren’t “funding it” per say, then the NPV argument is no longer an issue (if it’s even an issue to begin with). NPV only makes sense in relation to the inflation rate. That’s where the potential investment loss lies…or if the person dies before fully receiving the amount they paid in. It’s about the rate of return. But when you LIVE OFF social security I don’t think NPV is a big concern to those receiving SS checks! And frankly if there wasn’t a FICA tax it is possible that the retirement funds wouldn’t need to be as high as they are today either. When the US government pays a retirement program it IS being paid by the people to the people for the people. That’s the whole point of it.
Your concerns can be handled in ways that you’re not considering it seems to me and throwing seniors (and those following in their footsteps) under the bus is NOT the option here.
Social Security is intended to be self-supporting. if you want to act like it’s not, that’s your prerogative but there is zero consensus about that. Most people want it to be self-supporting. I do as well. I would like the DoD to have specific taxes allocated to it too.
And there is something wrong with more real resources going to support seniors. I am ideologically opposed to it because I do not support the infinite growth paradigm that is implicitly behind it. Baby boomers are getting more back than they put it in. In a world of dwindling finite resources, the end result will almost certainly be less for the generation that follows.
I think that’s about all I am going to say on the issue.
P.S. – I am not “throwing seniors under the bus” by advocating an increase in minimum ages. Raising the age of collection (something every other developed country is doing, by the way) is something that ends up costing people like me and not current seniors. They will get their fair share and more.
if you didn’t pay into it then you wouldn’t have those concerns.
The baby boomers created their own NPV value b/c they are the ones that increased the value of their own nation, so why shouldn’t they get good services in retirement? They were the juggernaut economically, now you resent them for getting cared for in retirement as if they didn’t earn it?
Of course they’re going to get more resources than most of the other people in the nation…they are the largest part of the population! In fact the baby boomers get most of the real resources now and I don’t see anything wrong with that…in fact that makes perfect sense really.
And by the time we retire the technology and services will be even better than it is today (hopefully at least) and you’ll also get a better value in it too…if we still decide to pay for it.
“Funding” programs comes from legislation passed by Congress not from tax dollars so wanting to “tag” tax dollars as going to this program or that program is not accurate to begin with anyway. It’s like trying to tag drops of water in a river that contribute to the ocean. It doesn’t really work like that and really it’s a pointless exercise all around.
How is pushing back the retirement age on seniors and lowering their payments that they already paid into not throwing them under the bus especially when many of them can’t afford much more as it is? Just b/c you think they’ll get their “fair share” (whatever that means) is not valid enough for people that live off those payments and are already having a very hard time finding new, sustainable employment at their age. What exactly do you think that is?
Again if taxes weren’t a part of this you wouldn’t be feeling as if you were personally at a loss.