Social Security, Ponzi schemes and why the government isn't 'stealing' your money

Last night’s Republican debate was focused squarely on the economy, on topics ranging from tax reform to income inequality.

That’s an improvement from the previous debate, held two weeks ago, which was also supposed to be about the economy. Unfortunately the candidates didn’t talk too much about that – they were often too busy trashing the moderators (though to be fair, the moderators' questions did have an edge and did stray from “core” economic topics that most of us would expect).

But there was one big exception to that economy-lite debate that didn’t come up much on Tuesday: a lively discussion about Social Security, an interesting beast and a curious topic.

Yes, it is officially an “entitlement” program, so this makes it an easy target in a Republican debate. But it’s also a program relied on by about 65 million elderly people, most of whom vote, which makes it a difficult one too.

Politicians can scream and shout about what it is (and isn’t) because it’s a really old program, started in 1935, and one that isn’t really sexy. So most of us haven’t taken the time to understand how the program works and what its problems might be.

Two points were made in the October debate that deserve scrutiny. One was voiced by several candidates, from Senator Rand Paul to Governor Chris Christie: namely, that the government has been “stealing” from Social Security.

The other, suggested by Governor Mike Huckabee in the debate but also an idea Senator Ted Cruz has claimed previously, is that Social Security is a giant Ponzi scheme.

Let’s discuss why this is a terrible misrepresentation of this program and how Social Security actually works, starting with the second point.

Social Security: just a Ponzi scheme?

What is a Ponzi scheme?

The Ponzi scheme is named after Charles Ponzi, who in 1920 was charged with more than 80 counts of mail fraud and was found guilty of scheming his investors out of their money.

Although originally he profited through arbitrage – buying postage stamps in one country and trading these for more expensive postage in another country – he graduated to a system that promised obscene profits (50% in 45 days, for example). His new system worked by paying off old investors with the money brought in by new investors.

That’s it! The system doesn’t have an investment vehicle and doesn’t require any research – the Ponzi ringmaster can pay high returns to investors (and keep a tidy sum for him- or herself) by bringing in new investors. Of course, once the new investors “dry up,” so do the returns, and the scheme fails. You would be correct if you identified this is what Bernie Madoff did to his clients.

Social Security is not this.

Social Security is actually two programs: the Old-Age and Survivors Insurance (OASI) element and Disability Insurance (DI). The OASI pays persons (and survivors of persons) who have contributed into the Social Security fund throughout their employment history. Disability Insurance, which began operating in 1957, pays disabled workers when their disability “retires” them prematurely.

Social Security is funded through taxes of earnings. When you look at your wage stub (if you are employed by someone other than yourself), you will notice the dreaded FICA line. FICA stands for the Federal Insurance Contributions Act, which empowers the government to tax your earnings and add money to one of the two Social Security buckets (OIDA and DI). FICA currently taxes employees and employers 12.4% on the employee’s earnings – half paid by the employer and the other half paid by the employee. The tax is levied on the first US$118,500 of each person’s earnings.

The money collected – and not spent – then goes into two large trust funds, which currently total $2.8 trillion in assets.

Ponzi or not, is the government stealing our money?

And that brings us to the other point.

“The government has been lying to you and they have stolen from you,” Governor Christie said during the debate. He was referring specifically to the Social Security system and this trust fund, which, claims Christie, is filled with nothing but IOUs. Well, in a way, he’s sort of correct.

The FICA tax isn’t collected specifically by the Social Security Administration (SSA). There is no “big room” or vault at the SSA where all these funds end up. Rather, the government allocates to the SSA the funds that it needs to pay out beneficiaries and administrative costs and then allocates the rest to be used in other ways. Of course, the SSA keeps a running tab, so to speak, of the amount of money that should be in the OIDA and ID funds.

So the federal government is taking the money out of these buckets and spending it? Yes.

The government has no use for a big pile of money other than to spend it on the things the country needs (like education, hospitals, roads and national defense). But the government isn’t just taking the money; it’s actually borrowing, and paying interest to the funds.

In exchange for the cash, the government puts treasuries in its place. So yes, the “vaults” are filled with IOUs, but at least they’re earning interest, and the US has yet to default, or not pay back what it owes.

Is this a bad thing? Nope. It’s a terrific thing: the parts of the government that need money are allocated funds through the issuance of debt and the SSA funds generate interest.

So is this the same thing as a Ponzi scheme? There are some similarities. For example, when I paid $14.53 in FICA taxes in 1985 from a pay stub delivering newspapers door-to-door (yeah, I actually had that job), that specific $14.53 probably didn’t stay in the Social Security funds. Instead, it might have paid for a railroad worker’s disability check or a retired person’s benefits or been leftover money that helped pay for my children’s education (in exchange for a treasury bond).

So my money went into the hands of somebody else – definitely a Ponzi scheme. Except it isn’t. Remember, a Ponzi scheme has no real investment vehicle – money is simply recycled from new “investors” to existing “investors.” Social Security essentially invests in treasuries to secure returns in the future (and, if that money in 1985 was used to purchase a government bond, it would have received around 8% a year in interest).

There’s a hole in the bucket

But even if Social Security isn’t a real Ponzi scheme, some of the candidates have made good points.

Senator Rand Paul and Governor John Kasich both pointed out that the Social Security funds are forecast to run out in the not-so-distant future. In the table below, I use data from the Congressional Budget Office (CBO) to illustrate how the Social Security fund is faring and how long it will last.

Each year, the CBO and SSA track the actual tax revenue building up the fund and the outgoing allocations from the fund for each of the two Social Security programs (OIDA and DI). If the difference between revenues and outlays is positive, the extra cash collects in the fund (along with all the interest earned from lending to the federal government). If it’s negative, money must be taken from the fund to cover the shortfall.

Using these forecasts and making some simple assumptions, I show that the fund will run dry in 2030, because, at that time, the dollars exiting the fund are greater than the money entering the funds. When that happens, the Social Security Administration can no longer make the payments to recipients.

How to patch the hole?

Clearly that’s a problem, but it has nothing to do with the government borrowing from the fund, since it always pays that back.

The obvious solutions come from both sides of the equation – the system needs to find a way to slow benefits or to increase revenue (or both).

The difficulty with the solution process, however, is that nobody wants to suggest increasing taxes (promises about tax increases will not get you elected!), and there are a lot of people who are currently relying on Social Security to pay their bills (promising to cut Grandma’s benefits will not get you elected!).

This is a real problem and needs real solutions, but moaning about the government stealing, cheating and scheming its way around this program will not solve the issues that are clearly coming our way.