Saturday, July 23, 2011

Entitlements and a Clash of Generations ... What's a Ponzi scheme?

We adopted social security in 1935. The normal retirement age was established as age 65, and normal life expectancy was about that same age. As a result, individual social security payments weren't going to be paid to very many people for very long, if at all. Things have changed.

Two words will explain much of the entire debt, deficits and financial dilemma confronting America today: DEMOGRAPHICS and ENTITLEMENTS. As a citizenry, we're living much longer, and we've been retiring earlier. A double whammy.

Although it wasn't intentional on the part of us oldsters, we're in the midst of pulling off perhaps the biggest generational heist in history. Comparing our situation today to an unintentional Ponzi scheme is absolutely appropriate. We'll soon see just why that's the case.

Named after the infamous Charles Ponzi, a Ponzi scheme takes place when the "investment" money paid to investors is not the result of money earned through investing. Instead the money paid out comes from money received by the "investment fund" from either the original or later investors. A pays in, B pays in, B's money goes to A. C pays in, C's money goes to B. D pays in, D's money goes to C. And on and on and on until the inevitable collapse occurs.

The original "investors" believe they are being paid as a result of the investment returns due to the acumen of the fund manager, but they actually are being paid with new money received by later "investors". For those familiar with chain letters, that's the basic idea.

In a classic Ponzi scheme, there are no investments, so no money is earned. To keep going, the scheme merely requires a good story and an ever increasing inflow of money from old and new investors. Only when outflows begin to exceed inflows will the scheme actually collapse. But it is destined for eventual collapse from the very outset. The last people to put their money into the "fund" lose their entire "investment". The next to last investor loses as well. And so on. The "investment" message is simple: if you're going to involve yourself in a Ponzi scheme, get in first and get out first. Otherwise you're destined to lose.

Let's compare a Ponzi scheme to our social security "insurance" system. If we begin a social security "insurance" retirement system where few individuals are eligible for benefits initially, but many others are paying into the fund in order to provide those few benefits, the retirement payments can be funded indefinitely because of the new money "contributed" by the many workers.

As decades go by, more people retire and more benefits are paid, but lots of cash is collected each year, so the cash contributed is greater than benefits paid. So far, so good.

Eventually, however, new investors catch wind of the scheme and begin to wonder if they will ever receive a satisfactory return on the monies they're "investing" in the scheme. They begin to doubt if they'll ever receive anything from the fund.

At this point they stop investing, and the beneficiaries stop receiving payments. The original beneficiaries have died, but the game is now over for those still playing. There's no new money coming into the fund.

It's at this end point that "investors" learn that there have never been any investments. Just a Ponzi like stream of new money used to pay those who are receiving benefits from the scheme - er- social security insurance fund.

Now let's go back in time to 1935, then move forward to the beginning of the post World War II baby boom period and finally we'll look at the situation today.

In brief, demographics have played a huge part in getting us to the sorry financial state in which we find ourselves today. The sad part is that this has come as no surprise to those charged with running and funding the social security system. We've been calling the post World War II demographic shift the baby boom generation for several decades now, so it's not a surprise. We've definitely seen it coming for a very long time.

In 1935 we had a population suffering through the Depression. Life expectancy wasn't much beyond age 60. The retirement date for the newly enacted social security legislation was established as age 65. We began paying monthly benefits in 1940 when Ida May Fuller received her first monthly check for $22.54. Since she had paid into the fund a total of $24.75 during the three preceding years, she received more that the total she'd contributed when she received her second monthly check.

Ida May lived to age 100 and collected a total of $22,888.92 in social security payments. Not bad for a total investment of $24.75. The demographics at that time, meaning many working for the few retired, acted to make things great for Ida and not even onerous for her fellow citizens. So far, so good. But free lunches always look good, at least until they're not.

When World War II ended, the baby boom generation entered the picture. The boomers grew up and then went to work in the 1960s. Now in the 2000s they are entering their retirement years.

What the baby boom segment says about demographics is dramatically different than the circumstances that were in effect in Ida May Fuller's day. Baby boomers worked and provided many workers for relatively few retirees in the 1970s, 1980s and 1990s. Now that's all changing.

And in large part, that demographic change, along with the similar impact of medicare/medicaid, is why we have an unfunded entitlements liability of ~$100 trillion today. What will we do about it? That's the question.

The unintentional but very real effects of our Ponzi like scheme for entitlements funding haven't been in the spotlight until now. There were no baby boomers in 1935, and the boomers were a helpful part of the "many" working in the latter part of the 2oth century. Only now are the boomers retiring in big numbers and by so doing also leaving a hole in the "many" working segment of our society.

Relatively speaking, we'll go from many workers to fewer workers, and at the same time we'll go from few retirees to many retirees. In a nutshell, that's the demographic effect on the entitlements issue confronting America. The party's over.

So what have we been doing to fund those baby boomer benefits? Not much, if anything at all. We're getting older, but we're still using the cash basis of accounting in government, just like all good Ponzi schemes are prone to do. As a result, we have no real money to pay future social security benefits other than current payroll contributions. President Obama's comments in What About the Trust Fund are meaningful, to say the least.

The oldsters have been running a Ponzi like scheme, albeit perhaps largely unknowingly. We're now sticking the younger generations with the bill. In my opinion, it's a straightforward case of generational theft. Or baby boomers behaving badly, if you prefer.

Whatever we call it, it's simply unfair. Now that we know about it, what will we do to alleviate the problem, if anything? Well, that remains to be seen.

The youngsters didn't vote to give the oldsters the benefits. The oldsters did that. Should the youngsters now trust the oldsters to try to do the right thing? We'll see.

Thanks. Bob.

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