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What do Social Security and Madoff have in common?

Posted by Jamie Downey  December 30, 2008 09:20 AM

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It's difficult to comprehend how Bernie Madoff could have executed a $50 billion pyramid scheme that lasted over 30 years. However, like all pyramid schemes, it had to come to an end because there were not enough new investors to fund redemptions.

If it is true that all pyramid schemes are terminal, can we honestly expect Social Security to last indefinitely? It's not likely, especially considering that the Social Security Administration (SSA) itself has called the system unsustainable in the long run. One can expect significant changes to the system in coming years. By the time Generation X and Y reach retirement age, the system will be considerably different.

To support the notion that Social Security resembles a pyramid scheme, I compared the SSA and the Madoff fraud case. Here's where they share common ground:

1. Legitimate investment vehicles take investor funds and invest them in businesses, real estate, and other assets. These investments are intend to generate returns for shareholders. Madoff didn't do this. He paid off early investors with cash from subsequent investors. Investment assets were never purchased.

Similarly, Social Security has no investments. It pays retirees benefits with cash deposited by younger workers. What’s worse is that Social Security has taken in a surplus of funds over the years. Instead of investing the extra funds legitimately, the government spent it on other programs. Now Social Security is completely unfunded -- something that's illegal for companies to do but not the government.

2. Madoff's early investors received excellent returns, which averaged 12 percent to 14 percent a year. Similarly, Social Security provided excellent returns to its early participants. The first person to receive monthly Social Security benefits was a woman named Ida May Fuller. She paid $24.75 total into the Social Security system over a three year period, and received $22,889 during her lifetime. Even Madoff was not so egregious to provide such a large return to his early investors.

3. Each quarter, Madoff sent fraudulent monthly statements to his investors. These statements were works of fiction -- there were no assets backing these investments. Similarly, each year all Americans get a statement from the SSA. This statement too is a work of fiction. There are no real assets backing the annuity that's promised to us. Furthermore, Congress and the President can merely change the law and that promised annuity will vanish. The SSA's statement should include the same disclaimer that's required to be on all investment prospectus statements: “Actual results may vary.”

In the final months of Madoff’s fraud, there were some $7 billion in investor redemptions. Madoff frantically tried to raise enough money to fund these redemptions, but to no avail. Finally, he confessed to authorities and the fraud was revealed. In the not too distant future, redemptions from Social Security will start to exceed the cash inflows from taxpayers. At that point, the US government may need to raise taxes and cut benefits to head off this cash drain from their coffers.

My friends from Generation X and Y, be prepared: Those monthly checks from the US Treasury won't be what you expect.

This blog is not written or edited by Boston.com or the Boston Globe.
The author is solely responsible for the content.

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D. Abraham Ringer is a CERTIFIED FINANCIAL PLANNER practitioner and a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which his articles are directed. For more information please visit www.morganstanleyfa.com/ringer
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