You Can't Cheat an Honest Man

by James Walsh

  The District Court upheld this conclusion.

  For the next three years, Jobin convinced the federal bankruptcy court to avoid payments that M&L had made to investors. By 1996, when she finally liquidated the bankruptcy estate, she had recouped almost $10 million. So, while Jobin wasn’t able to balance the accounts of the bankrupt business, she was able to mitigate the damage.

  CONCLUSION

  Conclusion: The Mother of All Ponzi Schemes

  The later half of the 20th Century has seen a confusing mix of eroding public trust in certain institutions (and burgeoning trust in others), growing self-absorption among many people and an increase in material wealth that’s not always evenly distributed.

  The result is a favorable climate for Ponzi schemes. The uneven distribution of wealth encourages greed and fear. Self-absorption breeds secrecy and gullibility. The migration of public trust from dogged government regulators to vapid television celebrities creates a moral vertigo that makes crime all but inevitable.

  With Ponzi and pyramid schemes appearing in many places, people looking to make money have to move cautiously. It’s true that some of the biggest fortunes are made on the fringes of markets and industries. But these fringes can be treacherous places. “How do you know a partnership’s oil properties are really there, or that they really have bank accounts?” says Bill McDonald of California’s Department of Corporations. “You assume the [investment brokerage] does due diligence and that what they tell you is accurate.”

  If the progress of Ponzi schemes during the past hundred years has proved anything, it’s that accuracy is hard to come by and trust has to be earned. This creates a conundrum: You need to be most guarded about precisely the people and situations most likely to occur. “I ask people: If it’s such a good deal, why is some guy you don’t know calling up to offer it to you?” says Peter Hildreth, New Hampshire’s securities regulator.

  To protect yourself from Ponzi schemes, remember the following, common-sense tips:

  • Don’t expect to get rich quickly. If an investment sounds too good to be true, it probably is.

  • Most bad deals offer high yields and meaningless talk of “guarantees” to “zero risk.” High returns almost always imply high levels of risk.

  • Be suspicious of any investment opportunity that seems inordinately complicated. This often is intentional—it encourages consumers to make the investment on faith.

  • Ask an investment adviser or accountant to review the prospectus or offer memorandum with you. Promoters who balk at this kind of review should be treated with suspicion.

  • Ponzi schemes often straddle regulated and non-regulated markets—but reputations travel. Check out the promoters with government regulators or industry trade groups.

  What’s remarkable about Ponzi’s legacy is that, no matter how many times investors lose money, new schemes keep coming forward. And the schemes don’t recognize demographic limits. Greedy and naive people of all sorts—young and old, black and white, rich and poor— line up to throw good money after bad.

  Social Security’s Troubling Profile

  Nobel Prize-winning economist Paul Samuelson famously wrote:

  A growing nation is the greatest Ponzi game ever contrived—and that is a fact, not a paradox. ...the beauty about social insurance is that it is actuarially unsound.

  Pundits who want to provoke response like to call the U.S. Social Security program some variation on “the biggest Ponzi scheme in the world.” And they have a point. Social Security shares many common traits with a classic Ponzi scheme. Like a Ponzi scheme, Social Security is a program that transfers wealth. It moves money from the current generation of workers to the one that came before, from people who earn a lot to those who earn a little, from single people to families and from people who die young to people who live a long time.

  Like a Ponzi scheme, Social Security relies on a steady stream of new participants. As long as the number of people in the American workplace grows or the money those people are making increases, the system can continue. As soon as that stream of participants plateaus— or, worse, shrinks—the system will collapse.

  Like a Ponzi scheme, Social Security’s collapse can be softened and slowed by careful management and one-time infusions of cash—but it can’t be prevented. The system’s defenders like to point out that the federal government won’t let Social Security collapse. But the Feds can’t control market forces.

  The growth of America’s non-immigrant population slowed after 1960. In that time, women have begun to have fewer children. The national average dropping from 3.5 in 1960 to 1.8 in the mid-1980s.

  During the same period, older workers began to retire earlier—but live longer. When Social Security was started, the average male worker retired at 69 and then lived about eight more years. In the mid-1990s, the average male retired at 64 and then lived 19 more years.

  The growth rate of the average American’s wages—which exploded for a quarter-century after World War II—slowed in the 1970s and 1980s as global competition and advances in technology reduced the need for unskilled, semi-skilled and even some skilled laborers. Those left often took a larger part of their compensation in the form of fringe benefits, which are not taxed by the federal government.

  Together, these factors suggest that by 2030 there will be only two active workers supporting each retiree collecting money from the Social Security system. That’s a big drop from the 30 workers-per-retiree ratio which existed when the program started, 7-to-1 ratio in 1950 and 4-to-1 ratio that existed even in the late 1980s.

  Still, Social Security remains a popular program. It helps millions of elderly and disabled people stay out of poverty. In the 1960s, the poverty rate among the elderly was twice as high as for all adults; by the 1990s, the rates were about equal. But this success is a double-edged sword. In 1996, 63 percent of all retirees relied on Social Security for the majority of their income. Making any reform that reduced benefits would be very difficult.

  The Hard Numbers

  Social Security participants are eligible for full benefits at age 65. They can draw reduced benefits—equal to 80 percent of the full amount— at age 62, but those benefits do not increase to the full level at age 65.

  Social Security funds are invested in non-negotiable Treasury securities, which means the money is spent on current government operations. Treasury securities pay low interest—about 5.8 percent a year, as opposed to the 11.9 percent that the Standard & Poor’s 500 stock

  index averages.

  Social Security has already been fiddled with numerous times. To keep the program solvent, payroll taxes have been raised repeatedly. In Social Security’s earliest days, the combined employee-employer rate amounted to only 2 percent on the first $3,000 of annual income. In 1996, the rate was 12.4 percent on the first $62,700.

  Despite these adjustments, by the mid-1990s Social Security was already in financial trouble. According to a 1995 report published by the Social Security Administration, retirees faced a 10 percent reduction in hospitalization and retirement benefits by the year 2010, a 27 percent reduction by 2020, and a 41 percent reduction by 2040.

  The primary suggestion for avoiding these cuts: More substantial increases in the payroll tax. At that point, a common suggestion was to add 2.2 percentage points to the payroll tax—raising it to 14.6 percent. The increase would buy another five years of solvency.

  Structurally, this is something like the roll-over of principle or other kind of deeper investment that Ponzi perps push on their loyal investors as their schemes mature.

  The First Sign of Collapse

  For people who retired before the early 1990s, Social Security was a great deal. Those who began paying into the system during the Depression typically took out twice as much as they paid in. According to one study, during the 1990s an average retired two-earner couple in their early eighties would receive Social Security benefits worth a total of $208,000. That’s $133,000 more than the value of all
Social Security taxes paid by the couple and their employers, plus interest.

  Many people think they are paying for their own retirement and that the money is safe because it is in the government’s hands. This sounds eerily reminiscent of the complaints that burned Ponzi investors make after a scheme collapses.

  In fact, the Feds use current workers’ Social Security contributions to pay the benefits of current retirees. The current workers’ own benefits will, in turn, be dependent on the working population in the future. This means there is no money in any account to pay any future retiree. Economists worry that, as the overall U.S. population ages, it will become impossible to come up with the money to pay promised benefits.

  In June 1996, Treasury Secretary Robert Rubin announced that government projections showed Social Security would be bankrupt in 2029. The same study projected that the trust fund which pays Medicare bills for 30 million seniors will be broke in 2001. The Social Security Administration also projected that in 2013 payments of benefits to retirees would begin to outstrip payments into the system. In short, the mass retirement of baby boomers will break the system.

  During 1997 and 1998, the federal government cut spending and collected enough tax to create a projected budget surplus for several years. This created much excited talk about bailing out Social Security. But even if all of the surplus is used to help the program, it won’t make an unsound proposition any more sound.

  Demographers and economists predict that in 2050, some four generations after the end of the baby boom, more than 15 million boomers will still be alive—and watching the mail for their Social Security checks.)

  The signs have already started to appear. In 1996, for the first time in the history of Social Security, some categories of new retirees—particularly middle- and high-income single males—could expect to get back less for their contribution to Social Security than if they had invested the same amount of money in low-risk securities.

  That projection held true even if the system managed to pay beneficiaries all promised benefits into the 21st Century. Most experts considered that an unlikely proposition—unless the Feds were able to pass sizable tax increases or other adjustments to the program. So, it seemed that a growing number of retirees would likely get substantial negative returns on their contributions.

  Social Security promoters insist that this doesn’t mean the scheme is starting to collapse. By their reckoning, such talk is politically-motivated rhetoric. “There’s been a steady campaign under way...to raise doubts about the solvency of Social Security, to lead to privatization,” grumbled AARP executive director Horace Deets in 1996.

  The History of the Scheme

  Social Security was never intended to be an investment plan for retirement. It was intended to be a sort of national insurance to supplement private savings and pensions.

  Franklin Delano Roosevelt and the other architects of Social Security believed that a pay-as-you-go system was needed and just, because—in the Depression Era of the 1930s—older people faced extreme poverty. But even these architects understood that the system needed limits. In 1939, Roosevelt’s Social Security Advisory Council wrote that support of retirees could not come

  at the expense of...lowering of the standard of living of the working population. No benefits should be promised or implied which cannot be safely financed not only in the early years of the program, but when workers now young will be old.

  The program’s administrators didn’t wait long to start ignoring that advice. And expanding the program became a routine process in Washington. One example: In the early 1970s, benefits were increased across the board by 20 percent. Another example: Almost immediately afterword, they were indexed to inflation.

  Richard Nixon would later call this move one of the biggest mistakes of his presidency. Considering how his presidency played out, that’s a big mistake.

  When the stagflation years of the late 1970s followed, with their theoretically impossible combination of recession and inflation, the indexed Social Security benefits disconnected from workers’ wages. The retirees getting government checks started catching up—and in many cases, passing—current workers in terms of disposable income and quality of life.

  Eventually, Social Security benefits were adjusted again so that they were indexed against real wages. This was supposed to prevent a repeat of the stagflation decoupling. More changes came in 1983—in a series of adjustments that program administrators called the “75-year fix.” This fix raised payroll taxes, taxed program benefits and phased in a higher retirement age.

  But even after these changes the system promised each successive group of retirees higher real benefits. Worse still, several generations of workers learned to expect steadily increasing Social Security benefits. Economic historians suspect that this expectation reduced savings—since people began to think that the federal government would provide for their retirement.

  This trend touched yet another familiar Ponzi scheme theme. Unsophisticated investors will sometimes load their investments into one scheme that promises huge returns. That many eggs in a crooked basket are likely to be broken.

  Investment banker and economist Pete Peterson dismisses Social Security as “a vast Ponzi scheme in which the first people in are big winners and the vast array of those who join late in the game lose.” Like a standard Ponzi scheme, Social Security only works if there are fresh people to bring into the system each year. Unlike a standard Ponzi scheme, the federal government forces people to participate.

  “There is no crisis situation with Social Security,” Shirley Chater, administrator of the Social Security program, told a congressional committee in 1996. She was trying to talk congress into giving her agency more money. But her effort backfired. Like any Ponzi perp, she’d cooked the books to make a better impression. Under questioning, she confessed to having counted only workers’ Social Security taxes in her analysis of the system’s return on investment, not employers’ matching contributions, which economists agree are paid indirectly by workers through lower wages or benefits.

  One senator was so angry at the dissembling that he attacked Chater for using “Disneyland financial analysis.”

  Stanford economist John Shoven puts it more plainly: “The current system simply isn’t financially viable. [It’s] akin to an inter-generation chain letter.”

  Possible Solutions

  “The growing disenchantment with Social Security is all but inevitable when you have a pay-as-you-go system in a low-growth world,” says White House advisory council member Carolyn Weaver:

  It’s been coming for a while. [Soon] the same old, conventional fixes like raising taxes or reducing spending [on benefits] aren’t going to cut it. Those tend to shift costs to the younger generation and make their rates of return worse.

  One poll, conducted by Newsweek magazine, found that 61 percent of adults are not confident Social Security will be solvent enough to provide benefits to them when they retire. This skepticism about Social Security, plus the fact that younger workers will not get the same favorable return rate on their investment as today’s retirees, is driving people of all political persuasions to believe the system should be fundamentally restructured.

  In the 1990s, Social Security’s defenders have argued that the program can continue for 60 to 80 years with a few minor modifications. If retiree benefits are gradually decreased by 1 percent a year or the tax rate used to support it is increased by about 0.25 percent a year, the program could last another three generations.

  The main problem with this scheme: The eventual collapse only grows bigger over time.

  Raising the eligibility age would also expand the program’s horizons. The move from 65 to 67 takes effect gradually, adding two months each year starting in 2003. (Some pundits argue that congressional staffers planned the change in such a way that their own eligibility wouldn’t be delayed.)

  Increasing the move from two months a year to three would mean the eligibility age would be 68
in 2012. The older starting age would lower the program’s annual expenses by an additional 5 percent.

  Many reform plans call for Social Security to invest its surplus funds more aggressively. In 1996, a White House advisory council on Social Security reform split on two close variations of this theme. One group supported a plan that would invest as much as 40 percent of reserves in stock-index funds, reduce average benefits by 3 percent, raise taxes on benefits, and extend coverage to excluded state and local workers.

  The other group supported a plan that would replace today’s system with a two-tier benefit approach. One tier would provide a flat benefit financed by almost two-thirds of the current payroll tax. A second would consist of an annuity created by mandatory personal accounts funded with the remainder of the tax. A tax increase would be needed to cover costs of a 70-year phase-in.

  “We have to go to seniors, and say, Look, we can’t keep this up,” said Nebraska Senator Bob Kerrey. “Yes, poverty is a concern. But please don’t tell me that every American over 65 is foraging in the alley for garbage or eating dog food. They’re going to Vegas with their COLAS—while kids don’t have computers in class.”

  The problem with changing from a pay-as-you-go program to a prefunded private retirement program is that one generation would have to pay twice—for the retirement of its parents and then for its own. But it’s a reckoning which some generation will have to bear.

  “The issue is simply that Social Security has become nothing but a giant Ponzi scheme where they’re relying on new contributions to make the payment to existing retirees,” says Jon Fossel, chairman of mutual fund giant Oppenheimer Funds Inc. “As with all Ponzi schemes, eventually you hit the wall when somebody wants their money back.”

  Allowing private investment introduces market risks into the Social Security equation, but proponents of this solution argue that a solvent system with risks is better than no system. Besides, most workers already plan to rely on other sources—separate company pensions, private 401(k) plans and IRAs—to provide the bulk of their retirement income.