Is Social Security a Ponzi scheme?

Recently one of my relatives contacted me, and there was desperation in her voice.  Immediately I worried it was about a health issue for her or another relative.  Fortunately, it wasn’t, but to her it was just as important. 

Her worry was about Social Security.  She had heard talk about Social Security going broke.  She had also heard of some calling Social Security a “Ponzi scheme,” and although she didn’t know exactly what that was, she remembered the disgraced investor Bernie Madoff being convicted of it. Her last comment was, “I want to know what Social Security has done with my money?”

I had several responses for my relative. First, I informed her the funds she and her employer had contributed to Social Security were not tagged with her name.  I told her to look at the name of the program.  It is not “Individual Security;” instead it is “Social Security.” 

Social Security was designed in the 1930s to guarantee some minimal level of financial security for older individuals, especially those who were retired. Contributions from both individuals and employers are all put into one large collection of money.  Noone’s name is attached to any of the money. 

Instead, when an individual begins receiving Social Security payments, a formula is used to determine the size of the payment.  Many factors go in to the formula, including life expectancy, lifetime earnings, and number of years worked.  The formula is also designed to help lower-income households more than higher-income households. 

What about the issue of Social Security being a “Ponzi scheme?”  A Ponzi scheme is a system where the supposed financial earnings to investors are paid by contributions from new investors rather than from investment earnings.  This is exactly what Bernie Madoff did. 

When some of the investments Madoff made for his clients failed, he began to pay the clients with contributions of new clients. Eventually, there were no investment earnings to pay his clients, so he began to rely completely on attracting new clients and new contributions.  Clients were led to believe Bernie Madoff was just a very, very smart investor.  But when the 2008 financial crisis occurred and new clients stopped investing with Madoff, existing clients wanting to make withdrawals found there was nothing to withdraw, and Madoff was exposed.

On the surface, the claim could be made Social Security is a Ponzi scheme.  Social Security relies on current workers contributing to the system in order to sustain payments to retired workers. If the relative number of existing workers to retirees drops, payments to retirees will also decline.  This is exactly what is happening today, as the growth of new workers is declining relative to the growth and longer longevity of retired workers.  Indeed, Social Security has already announced it will face shortfalls in payments to retirees beginning in the early 2030s.  As I have written in previous columns, changes to Social Security will likely be made sometime in the future to keep the system going, just like forty years ago when the same situation existed.

An important element of a Ponzi scheme is deception.  Investors are told their money is being invested and earning high returns, while what really is happening is the alleged high returns are only created with new contributors’ money. 

There is no deception in Social Security.  Anyone can read about how Social Security is operated.  My relative who thought Social Security invested her contributions only for her believed this because she never took the time to read about Social Security. When I told her how the system works, she was completely surprised. 

There’s another key difference between a Ponzi scheme and Social Security.   In a Ponzi scheme, new investors can stop coming.  Indeed, this is what caused the collapse of Bernie Madoff as the national financial crisis in 2008 caused potential new investors to hold on to their money.   In contrast, all workers – with a few exceptions – are required to contribute to Social Security.

Even if Social Security is not a true Ponzi scheme, there are still serious questions facing the system.  A big question is how the system will be changed to accommodate the new demographics.  To what degree should Social Security taxes be raised and benefits cut?  Should these changes be applied to all participants, or should there be differences between income levels?  Also, should Social Security’s investment portfolio, which is now limited to safe US Treasury securities, be broadened to include stocks, precious metals, and other options paying higher returns, but also carrying more risk?

Perhaps the ultimate question for Social Security is whether an option should be provided for “Individual Security.”  That is, should people be allowed to take some or all of their Social Security contributions and invest them as they wish?  The last time this idea was seriously proposed in 2005 it was rejected.

Social Security has been key component of individual retirement for almost a century.  It is also a special kind of retirement plan that relies on participation between generations.  While there are no secrets about how Social Security operates, still there are questions about whether it is the best system for everyone. In my opinion, this is a big and very important “you decide.     

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.