One of the most common myths about Social Security is that in some way it’s a Ponzi scheme. This myth persists because the money you pay into the system isn’t held in trust for when you retire but instead is used to pay benefits for workers who are retired right now.
This type of fraud, named after Charles Ponzi, who constructed such a scheme in 1920, pays old investors by using capital paid into the scheme by new investors. Since the scheme lures in investors by promising higher-than-average returns, it needs to continually expand in scope. The most famous Ponzi scheme was that of Bernard Madoff, who bilked investors out of $65 billion, the largest such fraud in history.
One of the most important things that differentiates Social Security from a Ponzi scheme is that the money in the Social Security Trust Funds is invested. An operator of a Ponzi scheme doesn’t invest, since that wouldn’t allow the scheme to pay out the high returns demanded by its investors. Social Security, on the other hand, invests in U.S. Treasury bonds, one of the safest investments in the world, since those bonds are backed by the full faith and credit of the United States.
Another important distinction is that Social Security is mandatory for U.S. workers. There’s no possibility of people suddenly deciding to opt out of it. Most Ponzi schemes collapse when a portion of their investors decide to take their money out of what proves to be phantom investments. But that can’t happen with Social Security.
Social Security funds are invested in U.S. Treasury Bonds, one of the safest investments there is since the bonds are backed by the full good faith of the government.
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Why, then, are there persistent rumors (louder during an election cycle) that Social Security is running out of money?
It’s true that over the years the government has had to make adjustments to ensure that the system continues to have the wherewithal to pay benefits. When Social Security began in 1935, it taxed just 2 percent of a worker’s earnings—1 percent came from the worker’s paycheck and 1 percent was paid by her or his employer. It taxed up to $3,000 in income. Today that tax has risen to 12.4 percent of a worker’s earnings, which is still split evenly between worker and employer, and the income level cap has been increased to $118,500. (Self-employed people pay a tax of 12.4 percent on their earnings.) So over time, Social Security taxes have increased.
Some people have charged that Social Security’s difficulties, real or imagined, are caused by the government burrowing into its trust funds and spending the money on various other projects. In fact, this charge misunderstands the fact that these aren’t really trust funds. They’re government accounts, and the money from them is invested.
The government funds Social Security in three ways:
Overall, the program is expected to run a surplus until 2020. However, the trust funds will be depleted sometime in the 2030s (exact dates vary, depending on who’s doing the estimating). Even in that case, using payroll taxes and income tax, the program can continue to pay out 77 percent of benefits. However, as you’ll see in the next chapter, there are a number of ways in which Social Security can be fixed that will make it solvent for a long time to come.
In addition to payroll taxes to fund Social Security, you and your employer each pay 1.45 percent tax to fund Medicare’s Hospital Insurance Trust Fund. High-income individuals pay an additional 0.9 percent to support Medicare.
One argument that’s been brought up a great deal is that Social Security is a burden on the younger generation. When the system was created, the argument goes, there were fifty-five workers to support each retiree, so the payroll tax each worker paid could be kept very low. But since 1935, the life expectancy of the average worker has dramatically increased. The result is that it takes more and more younger workers to support retired older ones. It’s been estimated that to continue to function, the system needs approximately 2.8 younger workers for each retiree Social Security supports.
If the ratio slips below the critical level, we will reach a situation in which too few workers must support too many retirees. This is the crisis that doomsayers are warning about. But is the situation as dire as they claim? Let’s look at what’s really wrong with Social Security and how it can be fixed.