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In 2008-2009 Bernie Madoff made headlines throughout the financial world when his wealth management business, Bernard L. Madoff, Investment Securities, LLC was discovered to have defrauded investors of billions and billions of dollars (estimates ranged from 18 billion to as high as 65 billion dollars, although $20 billion dollars stolen appears to be closer to the truth).
How did investors get duped by Madoff?
It was the lure of promised returns.
Madoff’s investment firm claimed an average annual return of 11% with very little volatility.
He was like the pied piper for investors and they blindly followed him.
Because of his long tenure in the finance industry (the technology his firm developed pioneered the formation of the NASDAQ), Bernie had wealthy investors ready to hand over large sums of money unquestioningly.
So elaborate was this scam that it is still uncertain when it actually began (in some interviews Madoff said he started in 1987, in others it was 1992).
And how did Bernie pull off a scam of this magnitude for so long?
Two words: Ponzi Scheme
A Little Background History:
Charles Ponzi was the mastermind behind an epic scam that bears his name (also referred to as a pyramid scheme).
Charles was born in Italy in 1882.
In 1903 he arrived in the United States with about $2.50 in his pocket (worth about $67.25 in 2018 dollars).
“I landed in this country with $2.50 in cash and $1 million in hopes and those hopes never left me”-Charles Ponzi
In 1919, Ponzi branched out with his own business and in the course of his dealings discovered a financial opportunity he could exploit, international reply coupons (IRC).
The intended purpose of these coupons was that someone could send correspondence internationally and the recipient could use this coupon to send a reply.
With great financial insight, Ponzi quickly realized that he could take advantage of a potential exchange rate (IRCs were priced at the cost of postage in the country of origin and could be exchanged for stamps to cover postage in the country redeemed).
If there was a difference in value in this exchange, a profit could be realized.
With inflation running rampant from World War I, IRCs purchased in Italy fulfilled the criteria needed to realize profits when exchanged for postage in the US.
Calculating expenses, Ponzi realized that the overall transaction netted a 400% profit, completely legal, using this currency arbitrage.
Needing capital to start this venture, Ponzi formed his own stock company, which was later named the Securities Exchange Company.
Investors were promised 50% return after 45 days and when he began to deliver on that promise word quickly spread.
Soon more and more investors were handing over their money to Ponzi who gladly accepted it.
The problem was the scalability of this venture.
The initial round of investing brought in about $1800.
This required approximately 53,000 IRC coupons to capture the IRC exchange profits necessary.
As more and more investors poured in (at the height of this scheme in July 1920 his company was bringing in $1 million/day) there were simply not enough IRCs that could be obtained and sold (it had gotten out of hand much earlier).
How Ponzi was able to manipulate these large transactions and still give investors promised returns was to build a pyramid scheme.
As more and more investors came in on later rounds, they built the base of the pyramid.
New money coming in was not buying IRCs at all, but simply turned around and returned to older investors as purported profit.
As long as the base was growing, the top of the pyramid could be held up.
This is where the financial venture turned from legal profits from arbitrage of currency to illegally stated profits and the Ponzi scheme was born.
Pyramid schemes by definition cannot be sustained for long periods of time.
Eventually there is not enough new investors/new money to sustain the promised returns to older investors.
When this happens and returns diminish or disappear, investors then start redeeming their original investments.
At a certain tipping point there will be a “run on the bank” and redemptions will exceed available cash and the whole house of cards falls down, which happened to Ponzi in August 1920.
When all was said and done, Ponzi’s investors lost around $20 million (approximately $261 million in 2018 dollars).
Ponzi was facing a lifetime in jail for 86 counts of mail fraud however he plea bargained and spent a total of 14 years in prison.
Bernie Madoff took the pyramid scheme to a much grander scale (53x magnitude to Ponzi) with his downfall initiated by the financial crisis when investors began redeeming money totaling $7 billion when there was only $200-300 million left.
On June 29, 2009 Madoff was sentenced to 150 years of federal prison at the age of 71.
“Okay Xrayvsn. Thanks for the history lesson but what does that have to do with dear old Uncle Sam!?!?!?”
Can you think of any government policy/program that can be thought of as a pyramid scheme in the making, having incoming “investors” buy in to support older “investors?”
If the first thing that pops into your mind is Social Security then you’re a winner.
“As a result of changes to Social Security enacted in 1983, benefits are now expected to be payable in full on a timely basis until 2037, when the trust fund reserves are projected to become exhausted. At the point where the reserves are used up, continuing taxes are expected to be enough to pay 76 percent of scheduled benefits.”- Social Security Office
As the population ages and more and more social security benefits begin getting claimed, there will be a tipping point where the base of the pyramid (younger taxed workforce) cannot sustain the top anymore.
Two things can happen.
The whole system falls down again like a house of cards or, more likely, there will be decrease in benefits/increase in age of retirement and/or higher taxes from the workforce.
Unlike the Ponzi/Madoff cases, these are mandatory “investments” in the form of required taxes.
So we all should look to (and thank) the younger generations ahead of us as they will be much needed to continue the ever-growing pyramid base.
Given the magnitude of money in play (around $2.6 trillion in the social security trust fund), this makes both Bernie and Charles look like amateurs.
Remember that Social Security benefits are highly regressive (the % of benefits received compared to contribution amount has “inflection” or “bend” points with subsequent decreasing levels of benefit after each bend point).
Physician on Fire does a wonderful explanation of this phenomena.
NOTE: The website XRAYVSN contains affiliate links and thus receives compensation whenever a purchase through these links is made (at no further cost to you). As an Amazon Associate I earn from qualifying purchases. Although these proceeds help keep this site going they do not have any bearing on the reviews of any products I endorse which are from my own honest experiences. Thank you- XRAYVSN
I once commented on a blog a long time ago that SS is a pyramid scheme, and some dude replied angrily with this long dissertation trying to explain why it’s different. He didn’t make his point.
Every time that letter comes each year showing me how much money they’ve taken from me in my career, it really depresses me to think of how much I could have had if I were allowed to invest it on my own, in a simple index fund. Oh well…
Thanks Dave for stopping by and commenting. Wow, I guess great minds think alike (albeit I am apparently way behind you calling out social security). I agree, social security especially for a high earner is a lose-lose situation these days. First due to the social security bend points, the higher you earn, the less return on each dollar you put in the system. Second, the way the benefits are being doled out, it will be unsustainable which means benefits will further decrease making our “investment” like a financial anchor that we are forced to take part in. Yeah I can’t… Read more »
It’s amazing how defensive people can get over such things, and then any argument they provide is not salient. For instance, they might say Social Security isn’t a pyramid scheme because it’s necessary, or because it’s run by the government rather than a person – neither of which negates the pyramid structure of Social Security. A better argument might be that the top is the same size of the bottom (even though in reality this may not be true) meaning that it’s not a pyramid in shape, or that a pyramid scheme always promises great returns, whereas Social Security makes… Read more »
Thanks JoeHx for your comment and insight. I agree 100% that a pyramid scheme is a pyramid scheme whether it is run by an individual or a government. True Social Security makes no claims for guaranteed returns. I think people paying into the system currently though think that they deserve the same benefits as the ones currently dished out which unfortunately looks highly unlikely. Thanks for stopping by!
That’s a great point and I didn’t think about it that way. This pyramid needs to either be toppled over or improved, stat – millennials in particular are coughing up way too much cash for a system that may not even benefit us at all.
Thanks Bob for dropping by. Yeah this system is antiquated and only getting more and more stressed (originally when social security was formed people were really on it for a few years before they passed because of average lifespan was a lot lower than today. Currently due to improvements in healthcare (thank you, lol), we have an increasingly aging population with octogenarians and older being on social security for decades. The baby boomers are now retiring en masse and thus projections say this system will start costing more than what is coming in depleting the funds for social security. Politicians… Read more »
Wow, I don’t think I ever knew so much about the actual details of a Ponzi scheme beyond it being a pyramid scheme. Super interesting post… and somewhat depressing ?
Well I’m glad to drop some knowledge (is that what you kids say these days? LOL) albeit on an incredibly depressing subject. What is more depressing is the amount of money that I have put into the system all these years (I’ve always hit the max cap since 2005) and I may not even get to see a good portion of the benefits that are being paid out for someone in a similar situation today.
I somewhat agree. But then annuity and life insurance can be view through the same lens, right?
I think Congress will get their act together someday to fix Social Security. They can raise the limit and increase the age.
Social Security is a good thing. If you leave it to each individual, they’d just spend it.
Good points about annuity and life insurance. I definitely think Congress will not let Social Security die off, too many people depend on it, but the solution will come so late in the game that the cuts to benefits and the increases to taxes will be quite large to make up for the time they have been kicking the can down the road. I too like the premise of social security as it forces an individual to contribute towards retirement. I wonder if it could be privatized though and individuals have an option of where there money is directed. I… Read more »
The pay-as-you-go system in place to fund entitlements worries me. I don’t see the programs as sustainable in their current form. I know changes will be made to reconcile the funding/disbursement gap which is sure to come as Baby Boomers retire and fewer worker bees fund their Social security payouts. As a result, my retirement planning doesn’t rely on Social Security to be part of my available income streams. Baby Boomers really have it best in America. They were the primary beneficiaries of Social Security, Medicare, private and public pensions, little-to-no education debt, lower formal education requirements for well-paying jobs,… Read more »
Thanks Young and the Invested. That is an incredibly insightful comment and I feel quite the accurate assessment of our situation. The programs in place are definitely not sustainable and very hard changes are in store. Your plan of not counting on social security is a good one. Although I know it won’t be completely taken away the numbers being paid out today will definitely be reduced dramatically. Just consider it a bonus if you get a monthly check in the mail.
The advancement of technology can really hurt social security. Artificial intelligence, automation, robots, self-driving cars… they are all going to replace much the “blue collar” (and maybe a lot of the “white collar”) workforce one day. With people out of work and wages low, nobody will be paying into the system. It will be interesting to see what happens to the house of cards…
That is a great point DMF. Also the FIRE movement is taking another component of wage earners out of the system to boot. Interesting times! Thanks for stopping by
I have been an advocate to allow people to make a choice – 1) stay in traditional social security or 2) let someone opt out, keep the payroll deductions and invest on their own. Option 2 would require someone to acknowledge they take full responsibility and will not go back after anyone if they suck at investing.
I never see this happening because traditional social security is too dependent on young workers supporting older workers.
Something has to give and Congress keeps punting the ball since they don’t want to tick off the people who vote them into office.
I think that would honestly be a perfect suggestion to allow an opt out but still require the money to be set aside for retirement and not just handed back to individual who would likely spend it.
Of course that suggestion makes way too much sense for it to ever get government approval.
And you are right the system is straining as is so if people would opt out (and honestly I could envision the majority of people doing so) the pyramid will be beyond the tipping point
I enjoyed the history lesson and even got the quiz question right! Social security!
I was going to take this in a real political direction but then I remembered that our personal finance blogosphere is my happy place.
I deleted my Suze Orman style rant and instead will continue to enjoy thinking about 4% rules and spreadsheets.
Lol. I think the FIRE community is still not gotten over Suze’s latest comment so glad you didn’t add gas to the fire. Lol
Another great post Xrayvsn! I never actually knew much about Bernie Madoff I only heard the name tossed around in the media a lot when this all came to light. Glad I read your post because I now understand it all a lot better. Social security really is a mess and I feel that most people my age and younger most likely will not benefit from it at all in the future. Your points made here were spot on.
Thanks Andrea for the comment. Madoff and Ponzi were amazing con artists indeed and the money involved was staggering. Social security is a bit of a mess and though I do think it will be around it will be drastically different from how it is now (likely less benefit and age to claim it will likely be raised)
The trust fund is presently slated to run out in 2033 not 2037. There are a lot of ways to take SS which bear looking into that improve payout. It’s not one size fits all. If you take a 70, your take will increase 8%/yr from you age 66 amount. In addition you can claim spousal benefits if your wife takes at her normal full age. In my case my wife will take, and I will claim spousal till I reach 70, then I will take and she will continue to take. At my death she will take survivor benefits… Read more »
Delaying social security as long as possible is probably the best return of your money.
It brings up an interesting point if you were in the fringe area of where social security is slated to run out or get drastically reduced. In this instance would you try to get social security as early as possible? And would you be grandfathered in at those rates whereas if you waited till 70 and in between congress cuts the amount down or raises the age even more would you get doubly screwed?
you don’t get grandfathered in under the present law. If you make 2K in Sept 2033 you get 1520 in Oct 2033, that’s what cut means. On Sept 1 you will get 100% benefit on Oct 1 you will get the 76% benefit. If you continue to wait to 70 you will get 8%/yr on the 76% benefit as far as I know. Depending on the amount of time between FRA and 70, say 3 years your compounded monthly benefit would be FRA x 1.26 So a $1000/mo benefit becomes $1320/mo inflation adjusted. Taking early is stupid unless you’re broke… Read more »
Good information to know If there is no grandfathering then delaying is definitely the way to go with the guaranteed increase in returns if it stays the same
There are break even points where 70 over takes FRA and 62 overtakes FRA or 70 I’m not exactly sure if or how
the 2033 cut affects those.
Thanks for this post! I’ve been saying this for years and people just roll their eyes at me. Another favorite of mine is when people demand THEIR money that they have paid into the “system”. People have quit discussing it around me because they do not like my explanation of how this actually works.
Great minds think alike ?. Thanks for stopping by and commenting
I really enjoyed the history lesson you gave with this post! Even if SS wasn’t a scheme, you shouldn’t rely on the government or your company’s pension plan as your only retirement income. Diversify, diversify, diversify.
I don’t even factor SS into my retirement calculations. Do you have any predictions of what is going to come of America’s debt situation?
Thanks Millionaire Dojo for the positive feedback. I will view any social security benefits I receive as a bonus as it will be impossible to predict what will happen to this system a decade or so from now. The one thing unfortunately that everyone is going to have to rely on (and hopefully it won’t undergo a drastic transformation in its benefits) is Medicare. Without Medicare I doubt anyone would feel safe retiring at all as health care expenses will be difficult to predict. So I am more concerned that that program survives relatively intact. The debt situation is an… Read more »
Yeah, I wonder at what point our debt is going to become too much debt. You can only borrow for so long! So much work to be done in this government…
By the definition explained here, Social security is absolutely a Ponzi scheme. Newer investors AKA the working majority, payoff the older investors AKA retirees.
As long as the entire population doesn’t discover FIRE and quit before Uncle Sam can drain all those life hours out of them and turn it into cold hard cash, the system should keep going just a while longer.
I agree. Maybe we should chill on promoting this FIRE stuff then. LOL
The saddest thing about Social Security is that it has zero real assets. It is just a bunch of IOUs from the federal government, which spent the cash as fast as it came in.
I think that the possibility of Congress changing the law to allow Social Security to continue running deficits after the trust fund is exhausted is close to 100%. They will just raise taxes and borrow heavily to pay the benefits.
Thanks Mark for the comment and what I feel is spot on insight. Great point that all the money coming in is not invested but just used. Had it been invested from the beginning in index funds it may have had a fighting chance.
There are a lot of collapsible parts to our economy or government that would qualify as a scheme. Social security does pose some risk but it seems to be a manageable “transfer payment” in the budget. Social security liability is now 17.4T but Congress can tweak the rules and make it more sustainable in the future without overhauling it. I worry more about the Medicare liability which is approaching 28T and the national debt that now exceeds 21.6T p.s. The comments appear in a bright white text when posted, but as I type this it is a light grey. It… Read more »
Thanks wealthy doc. Great point as well on the other financial arms of the government also having a risk (I too think Medicare is a big stressor in future).
I had noticed the comment issue before and may have to contact the developer to see if there is a workaround because there is no easy setting for me to change it. Sorry about that
Hey Wealthy Doc. I think I found a solution (went through all the documentation and discovered a workaround). Thanks for pointing it out. Let me know if this is better (may require another comment from your end. 🙂 Appreciate the help! -XRV
[…] However big yours is, it’s nothing compared to the size of the Ponzi scheme Bernie Madoff almost made off with. XRAYVSN thinks he’s identified an even bigger scam. Is Uncle Sam Worse than Bernie Madoff? […]
[…] I consider this “bonus money” as this may or not be there when I reach the age of qualification, briefly addressed before in a recent post. […]
I wonder what my benefits would be if I was forced to put it all in an index fund instead? I haven’t really thought of it like that until now though. Thought provoking for sure.
Thanks for stopping by and commenting. Really appreciate it. There are some factions that push for privatization of social security and take it out of the government hands. Others have proposed that they should be allowed to self invest (much like a 401k). It will be difficult to implement either because I think we are too far down the rabbit hole
[…] back to xrayvsn’s article, Is Uncle Sam Worse Than Bernie Madoff? This article takes us through a history lesson about Charles Ponzi’s legacy and how Bernie […]
Either Social Security will default on its promises (riots, social instability) or the government will inflate the hell out of the dollar (see above) to meet those commitments. There’s a third path of significantly cutting other expenses to fund SS but I think the likelihood of that happening is near nil.
Sadly I think those are all valid possibilities Moose. Hyperinflation is a concern for sure. I think the most likely scenario is a combination of increasing forced contributions (raising the social security cap limit) and decreasing benefits. Thanks for you input. Appreciate it!