Tuesday, April 12, 2005


A Ponzi Scheme?

By now, everybody has heard the term "Ponzi Scheme" used in conjunction with Social Security. Is it a Ponzi scheme? To call SS a Ponzi scheme is a little like referring to investing in derivatives as "gambling." It is both meaningless and, to a certain extent, correct.

First, derivatives. A derivative is a financial instrument that derives its value from something else. A good example of a derivative is an option to sell AT&T shares at $100/share in 6 months. If AT&T shares are trading at $90/share, such an option has a fair amount of value (because first you buy, then you sell, maing $10). If they are trading at $110/share, it has much less value. Folks who trade options in the hopes of making money are, more or less, gambling. On the other hand, what if you already own a share of AT&T. Having the option to sell your share at $100 hedges the possibility that your share will fall below $100. Now it's not gambling, it's insurance.

A Ponzi scheme is one in which your profits rely on your being able to pull more people into the scheme. For example, you might pay me $10 for the right to enter the scheme. This allows you to charge 2 more people $10 for the right to enter the scheme. You put up a $10 investment and get $20 back on it. Not bad. Unless everyone is already in the scheme, then you just lose your $10.

SS has some of the same qualities. Workers contribute their earnings today in the hopes of getting something back in the future. Who pays that money in? Folks not yet in the scheme. It certainly sounds like a Ponzi scheme.

Here's the difference, folks pay into the system while they are working (easily 30-40 years) and take out after they are done working (on average, 15-20 years). This is another way of saying: there are about 3.3 workers contributing for every 1 beneficiary.

If that ratio (worker : beneficiary) were to remain constant, you could pretty much establish a tax-level that would keep the system solvent over the long-term. A major problem that SS is having is that the ratio falls every year (from 40:1 at inception). Why? One reason is increasing life span -- few lived to see much benefits when SS was instituted. Another reason is falling birth rates. As the U.S. fertility rate fell below the magical "replacement rate" (the number necessary for the current population to produce enough children that the population would hold stead, ignoring immigration) the ratio of worker to beneficiary dropped.

SS Actuaries project this number to keep falling, and it well may. Medical science continues to improve, dropping mortality rates and increasing life spans, but the fertility rates are actually increasing and are now back over the replacement rate. Will this reverse the trend? Only time will tell.

If it does, you can expect to see "Ponzi Scheme" fall out of the lexicon of the SS critic.

As always, thanks for reading.

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