conversableeconomist

Charles Ponzi and Social Security

 In January 2009, Larry DeWitt of the Social Security Administration Historian\’s Office wrote a \”Research Note\” called \”Ponzi Schemes vs. Social Security.\”  DeWitt includes a nice short history of what Charles Ponzi actually did.

\”Charles Ponzi was a Boston investor broker who in the early months of 1920 was momentarily famous as a purveyor of foreign postal coupons who promised fabulous rates of return for his investors. Ponzi issued bonds which offered 50% interest in 45 days, or a 100% profit if held for 90 days….

Ponzi opened his company, \”The Securities Exchange Company,\” at 27 School Street in Boston the day after Christmas 1919. He was penniless at the time and had to borrow $200 from a furniture dealer in order to furnish his new office. Within days he was collecting money from his initial rounds of investors. He then expanded the circle of investors by collecting money from a larger round of investors. When the bonds of the first investors came due he paid them, with their miraculous profit, using the money collected from the second round of investors. The news of these extraordinary profits swept up and down the east coast and thousands of investors flocked to Ponzi\’s office for an opportunity to give him their money. Using the money from this new surge of investors he paid off the next round of bonds as they came due, with their full profit, which excited even more frenzy. …

Ponzi started his scheme on December 26th. Precisely seven months later, on July 26th, at the insistence of the Massachusetts District Attorney, Ponzi quit accepting deposits from new investors. It was estimated that Ponzi had been taking in $200,000 a day of new investments prior to the halt. At that point he had already collected almost $10,000,000 from about 10,000 investors. As word got out about his legal troubles, worried investors swarmed his office. Ponzi confidently greeted them and assured them all was well. …

From July 26th until he was jailed on August 13th, Ponzi kept up this practice, appearing at the office each day and redeeming bonds from worried investors. During this time he actually redeemed $5,000,000 of his bonds in a futile attempt to convince the authorities that he was on the up and up. At his bankruptcy trial, it was discovered that Ponzi still had bonds outstanding in the amount of $7,000,000 and total assets of about $2,000,000. Indeed, the seemingly lucky investors who redeemed their bonds after July 26th had to return their windfalls to the bankruptcy court to be distributed among Ponzi\’s larger circle of creditors. Ultimately, after about seven years of litigation, Ponzi\’s disillusioned investors got back 37 cents on the dollar of their principal, with, of course, no whiff of any profits from the nation\’s first and most notorious Ponzi scheme.\”

How does Ponzi\’s arrangement differ from the Social Security system? As DeWitt points out, the U.S. Social Security system is a transfer program between generations, from those in working age to those in retirement, not a pyramid scheme that relies on attracting continually increasing numbers of \”investors\” to pay off those who invested earlier. DeWitt writes: 

\”If the demographics of the population were stable, then a pay-as-you-go [Social Security] system would not have demographically-driven financing ups and downs and no thoughtful person would be tempted to compare it to a Ponzi arrangement. However, since population demographics tend to rise and fall, the balance in pay-as-you-go systems tends to rise and fall as well. During periods when more new participants are entering the system than are receiving benefits there tends to be a surplus in funding (as in the early years of Social Security). During periods when beneficiaries are growing faster than new entrants (as will happen when the baby boomers retire), there tends to be a deficit. This vulnerability to demographic ups and downs is one of the problems with pay-as-you-go financing. But this problem has nothing to do with Ponzi schemes, or any other fraudulent form of financing, it is simply the nature of pay-as-you-go systems….The first modern social insurance program began in Germany in 1889 and has been in continuous operation for more than 100 years. The American Social Security system has been in continuous successful operation since 1935. Charles Ponzi\’s scheme lasted barely 200 days.\”

Thanks to David Henderson at EconLog for the pointer.

conversableeconomist

Can Later Retirement Ages Save Social Security and Medicare?

Social Security and Medicare have both made promises about future benefits that their current sources of financing won\’t allow them to keep. If we moved back the retirement age, would it fix these programs? Short answer: moving back the retirement age could have a large effect in addressing the financial problems of Social Security, but would have a much smaller effect in helping Medicare.

For Social Security, the website of the Office of the Chief Actuary has estimates of the cost savings from a wide variety of proposals. Proposal C2.6, for example, reads: \”Increase the normal retirement age (NRA) 3 months per year starting in 2017 until reaching 70 for those attaining age 62 in 2032. Then increase the NRA 1 month every 2 years thereafter. Note that the NRA would increase from 66 to 67 faster than under current law. Increase the earliest eligibility age (EEA) from 62 to 64 at the same time the NRA would increase from 67 to 69; that is, for those attaining age 62 in 2021 through 2028. Keep EEA at 64 thereafter.\”

Those who will be 62 in 2032 are currently about 41 years old. Telling them now that early retirement will be 64 for them, instead of 62, and that normal retirement will be 70 for them, instead of the 67 years for this group in current law, seems to me completely reasonable. This change alone doesn\’t fix Social Security completely, but it would close about 70% of the projected funding gap for the program over the next 75 years.

For Medicare, in contrast, a higher eligibility age does a lot less. The Kaiser Family Foundation put out a report earlier this summer called Raising the Age of Medicare Eligibility: A Fresh Look Following Implementation of Health Reform.  The study assumes that the age of Medicare eligibility is raised from 65 to 67 as of 2014. Most policy proposals, of course, would have a slower phase-in. But the point here is not to analyze a policy proposal, but to get a handle on the changes that would arise when such a change in age was fully phased in. Here are some of the forecasts:

  • For federal spending, the older age of eligibility saves $31.1 billion for Medicare. However, a number 65 and 66 year-olds who were not eligible for Medicare would lack health insurance, and thus would be eligible for either Medicaid or for subsidized insurance under the new \”health exchanges\” in the health care legislation that President Obama signed into law in 2010. In addition, those 65 and 66 year-olds wouldn\’t be paying premiums into the Medicare system. After these offsets are taken into account, overall federal spending would be reduced by only $5.7 billion.
  • \”In addition, costs to employers are projected to increase by $4.5 billion in 2014 and costs to states are expected to increase by $0.7 billion. In the aggregate, raising the age of eligibility to 67 in 2014 is projected to result in an estimated net increase of $3.7 billion in out-of-pocket costs for those ages 65 and 66 who would otherwise have been covered by Medicare.\”
  • \”Medicare Part B premiums would increase by three percent in 2014, as the deferred enrollment of relatively healthy, lower-cost beneficiaries would raise the average cost across remaining beneficiaries.\”

A key underlying issue here, of course, is that health care spending tends to rise with age. Pushing back the age of Medicare eligibility affects the relatively health group a little above age 65, but it doesn\’t affect the health care bills of the more aged, and so it offers relatively small cost savings for the Medicare program. In a study from last year, Gerald F. Riley and James D. Lubitz report on \”\”Long-term trends in Medicare payments in the last year of life\” (Health Services Research, April 2010, 45(2):565-76). They point out that Medicare spending on those who die in a given year is much higher than on those who survive the year: in 2006, Medicare spending in 2006 on those who died in that year was $38,975, while Medicare spending in 2006 on those who survived the year was $5,993. Their estimates show that 25-30% of all Medicare spending is on patients in their last year of life, and that this number hasn\’t changed much over time, and isn\’t much affected by adjusting for changes in age or gender of the elderly over the last 30 years. 

conversableeconomist

If Public Pension Funds are in the Stock Market, Why Not Social Security?

State and local governments have assets in their pension funds that they invest and use to pay pensions to their retired employees. The federal government has assets in a trust fund that it will use to help pay for future Social Security benefits. But pension funds put their money in the stock market, and thus assume fairly high future returns: the median plan assumes a future return of 8%, according to a May 2011 \”Issue Brief\” from the Congressional Budget Office. In contrast, Social Security trust funds can only by law be invested in Treasury bonds, and thus get a much lower rate of return.

There is an ongoing dispute over what assumption is more reasonable. State and local governments can point out that the average rate of return on pension funds over the last 25 years is 9% in nominal terms (6% in real terms). The alternative view is that if these obligations are viewed as certain to happen, then they should be funded with extremely low-risk assets, like Treasury bonds. Using a high-risk asset like investment in stocks to fund a certain future obligation creates a mismatch. In the Fall 2009 issue of the Journal of Economic Perspectives (I\’m the managing editor),  Robert Novy-Marx and Joshua Rauh make this case.

If state and local pension funds were required to invest in safe assets, then they would need to assume a much lower rate of return on their pension funds. The CBO, for example, says that instead of state and local pension funds being underfunded by $700 million assuming an 8% rate of return, they would be underfunded by $2.9 trillion assuming a 4% rate of return. Conversely, if Social Security was allowed to fund its certain payments by putting 40% of the trust fund in riskier stock market assets and assuming a 6.4% real return (and phasing in this change over 15 years), then the actuaries estimate that the projected 75-year deficit of Social Security would be reduced by about one-third.

A consistent view should favor either that both state and local pension funds and Social Security can put their money in the stock market and assume high rates of return, or that neither should be able to do so. It can\’t make logical sense to say that for state and local pension funds, it\’s fine to invest in the stock market and to assume a high rate of return, but for Social Security it\’s too risky to invest in the stock market and thus necessary to assume only the low Treasury bond rate of return.

Oddly, however, it\’s common to find that those of a more liberal political persuasion are horrified by the idea of putting Social Security trust funds in the stock market, but would also be horrified by the enormous financial changes that would be needed if state and local pension funds were forced out of the market. On the other side, many of a more conservative political persuasion advocate putting some of the Social Security funds in the stock market, but like to argue that the deficits of state and local pension funds are overstated because they ought to be based on a lower \”safe\” rate of return.