Senator Ron Johnson recently told a group of donors that Social Security should be privatized because “it is a Ponzi scheme and the bonds in the Social Security Trust Fund are worthless.” In doing so, he demonstrates his misunderstanding of Social Security and of Ponzi schemes.
A Ponzi scheme sets up a fund and attracts investors who buy shares of that fund on the promise of very high returns on their investment. But there are no real resources backing up the fund, nor is there a reasonable-risk venture such as car production, or a medical technology invention. Instead, there is simply a sequence of investors in the fund, with early investors gaining a return via payments out of the fund financed by the payments into the fund by later investors. As the high returns get paid, the news travels fast, and more and more investors gleefully invest. As long as each successive group of investors is sufficiently larger than the preceding group, the promised returns can continue to be paid, and, of course, the scheme organizers reap huge profits as well. Eventually, however, the laws of arithmetic catch up with the Ponzi scheme. It becomes impossible for each succeeding investor group to be larger than the preceding group; the investor returns collapse, disappointed investors sue the scheme organizers, and, as in the cases of Bernie Madoff and Charles Ponzi, the organizers serve prison terms.
By contrast, Social Security is remarkably solvent; the system is going strong after 80 years, never having missed a payment. It is an insurance program backed by real resources, i.e., the taxes paid by current workers as well as the bond fund to be explained shortly. Most workers are required to participate by paying a payroll tax as their contribution to insure against poverty in their old age. It is designed as a “pay-as-you-go” system: current workers pay for current retirees with the expectation that, when they reach the age of eligibility, future workers will pay their Social Security benefits. This can be reasonably expected because over the decades each generation has added to and passed on the physical and knowledge capital of the nation. As a result worker productivity per hour has been increasing at a rate of roughly 1.5% annually. The immense value of this transfer of productivity from old to young enables younger workers to produce the national income out of which the old take their piece. There is no similar reciprocity in a Ponzi scheme.
Such pay-as-you-go systems are stable if each succeeding generation has a bit higher total productivity than the preceding one. Even though productivity per worker is rising, stability of an intergenerational financing of the Social Security system is hard to achieve when one generation is much smaller in number than the preceding one. Just such a problem was created when the baby boomers numbered 77 million and the subsequent generation numbered only 47 million. In 1985, when President Reagan foresaw the problem Social Security would face by 2012 when the boomers would begin to retire, he augmented the original pay-as-you-go design by increasing the payroll tax rate. This forced the boomers to add savings of their own to the payroll taxes they were already paying.
To understand the Reagan plan, we must follow both cash and bonds. Beginning in 1985, the increase in the payroll tax rate drove receipts above payments of retiree benefits, the difference generating a surplus. These surplus dollars were invested in a "Trust Fund," a reserve of special-issue US Treasury bonds that can only be traded between the US Treasury and the Social Security Administration. During the years that Social Security holds these bonds, Treasury has the corresponding cash, a chance to boost national economic growth by investing in assets like roads, bridges, broadband, and port facilities. Whenever payroll tax revenue is insufficient to pay scheduled retirement benefits, either due to the large number of retirees or setbacks such as the Great Recession of 2008-09 or the COVID-19 crisis of 2020, the bonds can be cashed in to add to the payroll tax. Contrary to Senator Johnson's misunderstanding, the bonds are definitely not worthless; they represent money loaned to the general public by boomers during their work years to be repaid later during the boomers’ retirement years. If the bonds were worthless, then the Reagan plan would have been massive theft. Fortunately, Ronald Reagan was no Charles Ponzi!
In the original 1985 plan, the payroll tax rate was calibrated so that the bonds would run out around 2060 after all but the most persistent boomers will have passed on. However, the combination of slower-than-projected economic growth plus the blessing of longer life will exhaust the bond fund around 2034. At that point, the payroll tax revenue will be about 79 percent of what is required for scheduled benefits. Consequently, just like a private insurance plan adjusts to changing demographics and returns on endowment, adjustments will be required to Social Security. Phasing in small changes, such as an increase in the eligibility age and raising the top end of the taxable income range, will make up for the shortfall.
Social Security is not a one-way transfer of funds from workers to retirees. Rather, it is a program that recognizes the reciprocity between generations. In a market system, with well-functioning capital markets, each generation’s productivity is enhanced by the efforts of preceding generations, and each generation pays a part of that increased productivity in the form of retirement benefits for the generation that made it possible. The young pay the old out of enhanced productivity made possible by the old when they were young.
William L. Holahan is Emeritus Professor and former Chair of Economics at the University of Wisconsin-Milwaukee.