A Great Pyramid Scheme


Fortune issue: April 13, 1998

First Principles


A Great Pyramid Scheme

By N. Gregory Mankiw

The federal budget may be close to balanced, but the U.S. government's fiscal problems are far from over. Looming on the horizon is the Social Security system. That problem stems from a sad but unavoidable truth: Social Security masquerades as a pension plan, but it's really a pyramid scheme.

The essence of a pension plan is that it accepts contributions from workers when they are young, invests them in stocks and bonds and other assets, and then pays out the return principal when employees retire. A pyramid scheme, on the other hand, never does much real investing. It offers fantastic rates of return to early investors by giving them some of the principal contributed by later investors. Eventually, someone is left shortchanged.

Now consider Social Security. A person retiring in 1940 earned an annualized inflation-adjusted return on his and his employer's contributions of about 135%--a return that makes Warren Buffett look like a slouch. Of course, such incredible numbers couldn't last forever, but many Americans still enjoyed a good deal: The return was 24% for someone retiring in 1950, 15% in 1960, and 10% in 1970.

The downward trend, however, is hard to miss. The return on Social Security fell to 8% for those retiring in 1980, 6% in 1990, and about 4% today. And the decline is hardly about to stop. Estimates put the unfunded liability at about $11 trillion--roughly three times the officially recognized national debt.

Seeing Social Security as a pyramid scheme shows why the aging of the population is so problematic. A fully funded pension plan doesn't need new participants to pay off old ones: It can just sell off assets. But new participants are crucial for Social Security, and they aren't coming fast enough. According to most projections, the number of people over age 65 is expected to more than double over the next half-century, but the number of people ages 20 to 64 will increase by only 25%.

The pyramid-scheme analysis also shows why we should not expect much from proposed reforms. Privatization of Social Security may be a good idea, but private pyramid schemes don't work any better than public ones. Investing some of the fund in equities may also be smart, but a pyramid scheme does not succeed simply by taking on riskier investments.

Bill Clinton says he wants to save the system, but if proposals speak louder than words, he is more likely to make it worse. The President has not said what he wants to do with Social Security, but he has proposed expanding eligibility for Medicare, Social Security's system program, which is funded in largely the same way. Clinton claims that Medicare expansion would be voluntary and self-financing, but actuaries know otherwise: When a health-care program is voluntary, the least healthy (and most expensive) individuals sign up. Moreover, if Clinton were right that the program would be self-financing, the private market would have provided the service already.

The President should be honest about the problem. The choices are simple but not pleasant: higher taxes, lower benefits, and/or later retirement ages. The longer we wait, the less attractive these options become.

The pharaohs of ancient Egypt achieved a sense of immortality when they built pyramids that would forever mark the landscape. Franklin Roosevelt did much the same thing when he created Social Security. American's pyramid, however, doesn't look nearly so nice at sunset.


N. GREGORY MANKIW is a Harvard economics professor and author of Principles of Economics.