Is social security the mother of all Ponzi schemes?

Governments pension schemes around the world have made gigantic promises. Will they be able to keep them? 

The Ponzi scheme created by New York businessman Bernard Madoff may result in losses of US$50 billion. This has invited some commentators to raise the point that America's Social Security system is an even bigger pyramid scheme. For example, Cliff Mason of CNBC calls Social Security The Real "Mother Of All Ponzi Schemes". (For international readers, let it be noted that Social Security is what public pension schemes are called in the United States.)

In a reply to such claims, Ponzi's biographer, journalist Mitchell Zuckoff, recently wrote that it is not accurate to call public pension schemes Ponzi schemes. I agree. However, even if journalists and news commentators sometimes get overly excited about their opportunity to raise a provocative point, they are not necessarily entirely mistaken either. Such is the case here.

The significance of the issue becomes clearer when you consider that the United States Social Security is among the least problematic public pension schemes in the world. It may not be the best run of such schemes (I'd say that ours in Finland is), but most US citizens are not so dependent on governmental assistance in retirement. In most European countries, the majority of people have virtually nothing else than the public pensions to rely on.

So, let us briefly examine the economic and moral nature of public pension schemes by analyzing three arguments put forward by Zuckoff in defense of Social Security.

Transparency and rates of return

The first argument is that "Social Security is exactly what it claims to be: A mandatory transfer payment system under which current workers are taxed on their incomes to pay benefits, with no promises of huge returns."

That is correct. Like most public pension schemes, the Social Security is a pay-as-you-go (PAYG) scheme in which current worker are paying for the current – not future – retirement benefits.

However, the true nature of public pension schemes has not always been clear, and I doubt that it is clear to all today. Many governments make calculations of workers’ expected retirement benefits, giving the impression that their retirement wealth is guaranteed and is already “somewhere out there.” (This is analogous to the way bank deposits are called “deposits” even though legally they are debt, and just a small proportion of the money is in the vaults.) Yet in reality, governments remain free to alter the benefit formulas unilaterally – there is no contract between taxpayers and government – and they probably will be forced to do so in the not-so-distant future.

Besides, to say that governmental pension savings entail “no promises of huge returns” is quite an understatement. Most public pension schemes offer basically no positive returns whatsoever. In PAYG schemes, the rule of thumb is that the return rate on contributions is equal to the growth rate of the labor force plus the growth rate of productivity. In countries with below-replacement fertility rates, this may translate into negative rates of return. Moreover, population ageing is going to require significant reductions in pension benefits, so that future retirees may receive just a small proportion of the money they poured into the system. Thus the situation is particularly alarming in European countries in which fertility rates are very low and most people have little else to rely on in old age.

Practically doomed to fail

Secondly, Zuckoff submits that unlike pyramid schemes, “Social Security isn't automatically doomed to fail."

Correct. But the expression “automatically doomed to fail” sets the standard rather high. As far as I can tell, human behavior is never fully predetermined (except in the sense that we cannot but seek happiness). The relevant question is here is whether, for all practical purposes, public pension schemes are viable. In the respect, my prognosis is dim.

To prevent the failure of public pension schemes, benefit formulas will have to be changed. But – lo and behold – this is not a magic trick that creates new resources out of thin air: it simply amounts to telling people they’ve just lost their hard-earned savings. Besides, the increasing pressures on public pensions will undoubtedly – I sorrowfully acknowledge – give further support to those that simply want to kill our elderly parents (or us!) in the name of forced euthanasia.

Gloomy speculations aside, can governments change benefit formulas? In a piece entitled “Grey Power Time Bomb” Professor Philip Booth argues that it’s easier said than done, at least in democratic countries. The ageing of populations will make retirees (and near-retirees) an increasingly powerful section of voters, who naturally do not wish to give up their benefits. Younger generations tend to be less interested in pension politics, as retirement is a faraway notion to them.

I do not wish to blame retirees for their demands. But the consequences are problematic. Politicians are reluctant to confront the issue, hoping instead that the next generation will solve it. That is dangerous, because when problems are not faced, they keep growing.

Subsizing the rich, and other dilemmas

The third argument for Social Security is that it is morally worthy. As Zuckoff frames it: “At the height of the Great Depression, our society (see "Social") resolved to create a safety net (see "Security") in the form of a social insurance policy that would pay modest benefits to retirees, the disabled and the survivors of deceased workers. By design, that means a certain amount of wealth transfer, with richer workers subsidizing poorer ones."

I do not deny that there is an aspect of solidarity in public pension policies, especially in their early stages, and that solidarity is an essential feature of humane societies. But matters are more complex, and rhetoric is no substitute for truth.

It has been disputed whether public pension schemes really subsidize the poor. In an important study entitled “The Progressivity of Social Security”, economists Coronado, Fullerton and Glass demonstrated that under reasonable assumptions, the US Social Security is on the whole not progressive but actually regressive. In the language of ordinary people, that means that it is the poor subsidizing the rich, not the other way around. The main reasons for this are that better-off people spend more time studying (hence they contribute a smaller number of years), and they tend to live longer (hence they receive a longer pension). In individual cases Social Security may help the needy, but it does not mean that it constitutes net wealth transfers in their favor.

There are other moral dilemmas too. Some time ago I argued that large public pensions tend to promote low fertility rates. The crux of the argument is that the social assistance state has replaced families, extended families and other primary organizations as providers of assistance in old age. It has also made it relatively more expensive to have a large family today. The substitution of the state for the family seems to have been a conscious goal of the 19th century German statesman Bismarck – who created the first-ever public pension scheme – and in that at least he has succeeded.

There is also strong evidence that the inappropriate design of public pension schemes has in many countries persuaded people to retire too quickly, causing both unnecessary economic burden and psychological adaptation problems. These are not just economic problems, but moral ones too.

Putting families first

Enough for criticism: What should be done about public pensions? There is no simple solution to such a complex issue, but here are my general ideas based on the classical notion of prudence, or practical wisdom.

The first step of prudent action is to look at the reality as it is. One implication of this is greater transparency with pension debt. In a recent paper entitled "A Bankruptcy Foretold: The UK’s Implicit Pension Debt," actuary Nick Silver calculates that if the government’s contribution-based pension promises are included, UK Government debt is now £4,097 billion, or £70,000 per person. That implies a national debt of 276% of GDP, as opposed to the official figure of 43% of GDP. In light of deteriorating public finances, it is worth asking how it is going to be paid, if ever.

Silver’s calculations demonstrate the sheer magnitude of pension promises – and the increasing difficulty with actually delivering them. If such is the case in the UK, one can only wonder what the figures would look like in countries such as France, Germany, Spain and Italy. And if this is the where we are after less than a century of public pension schemes, are they really worth salvaging?

The second step of prudence is to compare the strengths and weaknesses of all the alternatives – not with prejudice and attachment, but honestly and courageously. The history shows that there are plenty of non-governmental ways of providing for old age: families and extended families, mutual aid societies, charities and other voluntary organizations, part-time work and personal savings.

Two fundamental principles are especially pertinent here. The principle of subsidiarity demands that these primary organizations and solutions are given freedom of action without unnecessary government interference – or replacement. The state should only step in to coordinate and correct manifest problems, but even then one must not overestimate its ability to do so without errors.

The correlative principle of solidarity requires that all people are taken care of, and for this reason there may be some scope for government action. But here too one must remember that the state can only provide coordination and financial assistance – by its nature it is a legislature and a bureaucracy, not a substitute family and community.

The third and final step of prudence is judgment and action. Sometimes caution is called for – but not always, and never in excess. It is not always prudent – let alone just – to wait, like the Swedes are said to do, until others act first so that we can avoid repeating their mistakes.

Old age security is a complex matter, and there is a degree of sheer choice involved. The following statement by the medieaval Catholic philosopher Thomas Aquinas is worth keeping in mind by all who are responsible for the fate of nations – which ultimately includes all of us: Non potest certitudo prudentiae tante esse quod omnino solicitudo tollatur – the certitude of prudence cannot be so great as completely to remove all anxiety.

Oskari Juurikkala is author of Pensions, Population, and Prosperity (Acton Institute, 2007) and co-editor of Pension Provision: Government Failure Around the World (Institute of Economic Affairs, 2008). He is currently working on a PhD on financial markets regulation.

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