Pension and Ponzi Schemes
In the US, there is a heated debate about America’s government pension scheme Social Security. The Republican frontrunner for President Rick Perry has called it a ‘Ponzi scheme’, for which he was derided by the previous Republican frontrunner Mitt Romney. Here’s the question: is Rick Perry right. Is social security a Ponzi scheme?
Here’s my take.
Ponzi schemes are frauds. Here’s how the American markets regulator Securities and Exchange Commission defines Ponzi schemes:
A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.
With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.
The schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors that he could provide a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds to pay off earlier investors.
At heart here is trust. A fiduciary, someone who has a “legal or ethical relationship of confidence or trust regarding the management of money or property”, gains the trust as an agent acting on behalf of someone else. He then violates that trust willingly and intentionally by making promises that he knows he cannot keep. Further, the fiduciary, realising that his deception will be found out, is forced to either escalate or desist. The Ponzi scheme aspect comes when the fiduciary recommits to the initial fraud by pulling in more people to pay off the first trusting souls, escalating the deception.
So what happens is you trust someone, they violate that trust knowingly and intentionally. And cover this up by doing the same to others. As in all crimes, it is the cover up that is fatal.
In the old days, when economic growth was robust in North America and Western Europe. Defined benefit pension plans were the norm. The thinking at the time was that the corporation employing an individual and/or an individual’s government had an obligation to allow that individual to live a decent lifestyle after he stopped working. The thinking was, “If we can’t protect our citizens from the poverty we have worked centuries to overcome, what is the point of our being a rich nation, then?” The problem was that the economic growth and demographic expectations embedded into the promises companies and governments made in the 1950s, 1960s and 1970s proved wrong.
Here’s an example for you on final salary pension schemes from the British press just in the past day:
The deficit of the 6,533 final-salary schemes in the private sector had been £67.3bn at the end of July and £73.8bn in August last year.
There were 5,012 schemes in deficit and 1,521 schemes in surplus, the PPF said.
The schemes were hit by the falling value of shares in August, with the FTSE 100 having fallen by 7.5%.
This is the reason these final salary pension schemes are no longer the norm. The reality is that private sector pension schemes are built around 5-7% nominal GDP growth that includes 2-3% inflation and 3-4% real GDP growth. We are about to enter a period of low nominal GDP growth due to an overhang of private sector debts which will restrain consumption, consumer demand and economic growth. Nominal GDP growth of 3-5% is a more realistic upside scenario.
SocGen’s Andrew Lapthorne had it right when he wrote:
- Storing up problems for the next generation seems to be a recurring global theme these days. One such problem is the overly optimistic returns expectations embedded within many corporate and state pension funds. We estimate US pension funds are factoring in a nominal 9% equity return in the long-term. In the UK it is some 100bp lower.
- How realistic are these expectations? Well if history repeats itself, following such a poor 10-year return period as we’ve experienced, on average the S&P 500 has delivered 11% real over the next ten years. However, given the sharp rebound in equity prices since March 2009, half of that gain is already behind us. An analysis of Shiller PEs and future returns also indicates average real returns of just 1.7% going forward.
His conclusion: US Pension Funds are implicitly betting on Dow 40,000.
It is these same implicit bets of economic, industry or company growth during the inflationary 1970s which ballooned the pension costs of US manufacturing and airline industries and contributed to their collective bankruptcy. Companies and unions alike agreed to kick the can down the road by making this bet in order to allow employees to get through the inflation of that period. In the end, however, these bets went bust and so did the companies making them – years after the executives who made those fateful decisions had retired, of course.
In the public sector, gold-plated pensions in some states will consume 25-30% or more of tax revenues in future. That will mean higher taxes or reduced services. Voters will not go for that. In the next downturn, this issue will come to a head for municipalities and states, voters and muni bond holders alike.
Is it any different for federal government pension schemes in Europe and North America like social security? I say no.
Now if I were a political candidate, I don’t care how much I wanted to pander to the anti-government crowd. I would realise that attacking social security by calling it a ‘Ponzi scheme’ is setting me up for a rumble with retirees. And retirees vote. You can qualify this thing all you want, about how you mean reform will only happen for people below 50; it’s not going to work politically. What people will hear is “I’m running for office telling you I promise to help government renege on its promises to you.” Do you think that’s a winning pledge?
This is why Social Security and Medicare are third-rail political subjects. I don’t believe Social Security is a Ponzi Scheme, no. Government did not intentionally and wilfully make promises that it could not keep. The demographics and perpetual growth assumptions have simply caught up with us all. This is true for the private sector as much as it is for the public sector.
But I do believe that it is unsustainable for the US to keep the same promise to seniors today as it had 6 or 7 decades ago when life expectancy was much shorter. In real terms, retirees today have put in less in present value terms than they will receive in benefits. That is why there are large unfunded liabilities for social security.
There is no way around this except through cuts, tax increases, or deficits. And the deficits are the kind of thing that will cause inflation in an economy operating at full employment. You can print all the money you want to fulfill these promises. The bottom line is people want to be able to consume real resources in retirement not dollar bills; unless you commit greater amounts of society’s real and financial resources to retirees, that can’t happen. Put simply, future generations must pay more – that is unless you think we can grow our way out of the problem, which is a legitimate view some hold. For those of us under 50, sorry we have lost the retirement lottery.
The usual solution is to kick the can down the road. The progressive view that social security should not be touched implicitly says either we will grow our way out of this or we should accept the increase in resources allocated to retirees as part of the benefits of being in an advanced society. Tell that to young people straight out and they will reject this. The conservative view that we should privatise social security so that Wall Street can take those funds on the same boondoggle they have taken stocks and housing is insanity. With the deficit hawks on the warpath, it makes sense to me to reduce the deficits associated with social security. You could raise taxes, reduce benefits, reduce coverage, or delay benefits. I say delay benefits by raising the age of retirement to 67 and eventually even to 70 for those under 50.
If you raise the retirement age enough, you would then be able to increase the Social Security benefits you pay out. Of course, you would have to police age discrimination laws assiduously (see this recent example from Germany) and deal with how demographics play out negatively for minorities, manual laborers and lower-income people. The problem with entitlements is not social security but the rise in healthcare cost; and this is inextricably linked to America’s aging society and the outsized healthcare spending in America’s private sector. See “The correlation between healthcare spending and life expectancy.” America needs a better social safety net. So it is perfectly reasonable to make one available while lowering the deficit by reducing how regressive FICA taxes are while also raising the age limit.
Here’s something to think about as I put it early in 2009:
As I see this downturn lasting a very long time, even this kind of thinking will not go far enough in dealing with the economic insecurity to which we have all been exposed. Going forward, I see the whole idea of defined contribution coming under attack as people realize that huge financial burdens have been transferred from corporations to individuals. This conversation will take on a populist tone because I think many will notice that the owners of capital have become much richer over the preceding generation, while ordinary workers have not. With the illusion of wealth now gone as paper wealth declines, many will come to realize that we have just seen a massive transfer of risk.
Will this result in increased forced savings? Perhaps. After all, It is now evident to all that defined contribution pension plans work in good times but are woefully inadequate in bad times. I see this as the basis for some fundamental change. With that in mind, I say that if we are to follow the New Deal in any regard, it should be to increase the economic security of average citizens in a time of crisis. When politicians talk about change, this is where change must begin.