Social Security is no 401-k

Shikha Dalmia

In the interminable debate over whether Social Security is a Ponzi scheme or not (thanks a lot, Rick Perry!), defenders of the program are floating a rather novel argument. One similarity between the two is that neither invests its proceeds in return-producing assets. They are both pay-as-you-go schemes where the contributions of new participants are used to pay previous participants as I argued here.

But The Economist and the liberal blogger Matthew Yglesias insist that that’s not the right way to look at it. Social Security, they maintain, rises and falls with the economy, and hence is like a 401-k. Listen toThe Economist:

If you wanted to call Social Security an investment, you would say it is a play on the proposition that America's GDP will continue to grow over the long term. This is the safest play one can imagine making, which is why the returns are so modest. Like any investment, it could go bad. But if it goes bad, if the economy of the United States ceases to grow over the long term, it is inconceivable that any other investment large enough to feed a pension plan covering the entire working population could do better.

Yglesias puts the point even more bluntly:

Consider something that nobody says is a Ponzi scheme — your 401(k). What happens here is that you work while you’re working age. You earn money. You take some of that money to buy shares in firms. Your expectation is that at a future date when you’re not working anymore, you’ll be able to exchange those shares for money. More money than you paid for them in the first place. Why would that work? Well, it could work because you were just stupendously lucky. But the reason we anticipate that it will work systematically is that we anticipate that there will be economic growth. In the future, people will in general have more money, so assets will be more valuable. Save today, sell tomorrow.

Social Security is not a prefunded pension plan or a savings scheme. But its actuarial situation is just the same as a stock market investment in this regard. If future economic growth is lower than anticipated, it will be impossible to pay the anticipated level of benefits. On the other hand, if future economic growth is faster than anticipated, it would be possible to pay even more benefits than had been promised.

But if Social Security is like a 401-k, then Thomas Friedman is like Albert Einstein.

Yglesias and The Economist are half right that the fate of Social Security, like a 401-k, is tied to the economy. Both offer better returns when the economy is booming: 401-ks because the value of their assets goes up and Social Security because the tax receipts of the government go up. That’s one reason why many supply siders believe that the road out of the impending Social Security crunch is growing the economy, not raising economy-busting taxes.

But to say, as Yglesias does, that Social Security’s “actuarial situation is just the same as a stock market investment” is an overstatement that ignores the other half of the story which is this: While 401-ks are fully tied to the economy, Social Security is partially tied to the economy and partially to demography.

Indeed, over the years, Social Security returns have tracked less closely with the economy and more closely with worker-to-retiree ratios. Just as in a Ponzi scheme, initial investors received returns far and above their contributions or any actuarially sound principles. The very first Social Security recipient, Ida Mae Fuller of Vermont, paid just $44 in Social Security taxes, but collected $20,993 in benefits. Part of this was no doubt due to a windfall effect in that the system started paying out benefits to people before they had a chance to fully pay in. But part of it was that the worker-to-retiree ratio then was very high. This ratio, however, has been going south ever since, falling from 16-1 in 1950 to 3-1 today and 2-1 in 2030.

The economy cannot possibly grow fast enough to compensate for this plummeting ratio, which is why the natural tendency of Social Security returns is to go down. The question is only how much. They’ll go down less rapidly when the economy is doing well and more rapidly when it isn’t. And that’s by and large what’s been happening—especially in contrast to 401-k plans that are fully tied to the economy. (This declining ratio is the main reason why Social Security returns are now low; not because it is a “safe investment” as The Economist notes.)

Indeed, a 2005 study conducted by Thomas Garrett and Russell Rhine for the Federal Reserve Bank of St. Louis, found that private plans invested in the S&P 500 offered better monthly returns (based on a 56-year average rate or return) than Social Security to retirees of every income level. They note (and please check out Figures 5, 6, 7 and 8 that they allude to):

For those people retiring at age 62, none would benefit more from the current Social Security system relative to private investments in the S&P 500 (Figure 5). A person retiring at age 65 will only benefit more from Social Security relative to a private investment in the S&P 500 if he is a low earner and lives to be at least 96 years old (Figure 6). Finally, for those retiring at age 70, the only individuals that benefit more from Social Security are low earners who live to be at least 94 years old and average earners who live to be at least 108 years old, assuming an investment in the S&P 500 (Figure 7).

The bottom-line is that Social Security is a Ponzi scheme because its returns are linked to the number of participants. But in and of it self that is neither good nor bad. Ponzi schemes can work if they have an endless and growing supply of new investors/workers able to pay sufficient amounts into the system to support the earlier ones. That, however, is not the case with Social Security—which is why it is a bad deal compared to private alternatives—and it will only get worse for many years to come. Much worse.