Pension Ponzi Scheme Dwarfs Madoff Scam

The more I read about Madoff, the angrier I get. This con artist not only screwed over his fellow Jews, he also screwed over many innocent victims of all faiths who benefited from the charities his clients set up. Ripples from the Madoff scandal have spread everywhere, including Harvard's Medical School and pension funds.

But as bad as the Madoff scandal is, it pales in comparison to the greatest Ponzi scheme that is still going on today - the pension Ponzi.

Stick with me, I will explain my reasoning below. First, this article from Jay Ambrose, Madoff only the No. 2 Ponzi scheme:

It's an astonishing story. This seemingly trustworthy guy named Bernard Madoff was supposedly investing something on the order of $50 billion for some of America's richest people, pretended it was earning gobs of interest, actually used the principal of some to pay others wanting redemptions – and lost practically everything.

Here's a more astonishing story. Our seemingly benevolent federal government has taken from the public enormous sums of money for Social Security and Medicare, made it seem it was putting much of it in a trust fund, actually ran up stratospheric sums in unfunded liabilities and is now faced with major perplexities.

There's a close but imperfect analogy here, because both Madoff and the government have engaged in something approximating a Ponzi or pyramid scheme in which the money of new investors pays off old investors until finally there's nothing left, and everyone goes home broke.

The pretense used to be that when you coughed up your payroll tax, you were actually putting money into a personal Social Security account for your own future benefit. What's actually happened, of course, is that the taxpayer dollars go to pay the immediate benefits of today's recipients, whose numbers are about to vastly increase, while the surplus magically disappears into the supposed trust fund.

If you conceive of a trust fund as actual assets held someplace, there is no such thing, just a government obligation to repay the money someday. The surplus theoretically holds down deficits and debts so that its retrieval through borrowing won't be devastating, but, in fact, our spendthrift government has been racking up record deficits even after using up the surplus dollars, and what's facing us is a fiscal doomsday.

According to Heritage Foundation analysts, the unfunded liabilities for both Social Security and Medicare add up to more than $46 trillion, some 50 times this year's approved bailout funds, and the equivalent of having to come up with money comparable to the bailout billions "every single year in perpetuity."

That figure of $46 trillion, Heritage calculates, is more than all the taxes collected since the nation's founding. The prospect is devastating tax increases or scrapping everything else the government does or facing economy-wrecking deficits or some combination of the three.

The Madoff-and-entitlements analogy does break down on several points. For one, it's not the intended entitlement recipients who may suffer so much as the taxpayers both rich and not-so-rich having to make up for the lost money. For another, it was possible to ferret out what was happening as our entitlements programs got us into a jam. While Heritage and other think tanks would like the government to be more "transparent" about the entitlements issue, the facts exist for those willing to dig. Madoff's clients apparently had no way to get at the truth.

And while there may be no way for those who invested with Madoff to get more than a smidgen of their money back if any at all, there are solutions to the Social Security and Medicare shortfalls. For instance, you can change the index establishing future Social Security payments so that they do not increase beyond the cost of living, helping to make a major difference in payouts. Fixing Medicare is more complicated, but doable if the government acts soon. Right now, most baby boomers are contributors to the systems, but will soon start becoming recipients in huge numbers, a change that will make repairs exceedingly tough.

Two things you don't want to do – start new entitlements until we've fixed the old ones, or try to solve the entitlement problems just with more tax money. That would be about the same as Madoff trying to get out of his hole by seeking more investors.

The British Telegraph also carried an article stating that just as Bernard Madoff is alleged to have relied on payments in from new investors to pay out returns and promote a $50 billion fund that scarcely existed, the British government continues to issue promises which it hopes future generations will honor:

Christmas came early this week for 95,000 public sector pensioners. After questioning in the House of Commons, Cabinet Office Minister Liam Byrne admitted that they had been overpaid a total of £126m since 1978 but emphasised that they would not be required to pay the money back.

Particularly at this time of year, it makes a pleasant change to see some pensioners actually gaining from the sort of bureaucratic bungling with which we are now so wearily familiar and utterly fed up. All things considered, most people will be willing to set aside any Scrooge-like tendency to ponder upon who is paying for the politician to pose as Father Christmas.

However, a slight chill is placed on this cheery scene when you consider the uncertainty which these pensioners now face over what they will have to live on next year after their incomes are cut to the correct level. Perhaps equally galling, from the point of view of the majority who live in England, is the news from Scotland that the minority who are in receipt of overpayments north of the border will continue to be overpaid for as long as they live.

Good for them, you may very well say. After all, students receive grants in Scotland which are no longer available in England and the elderly receive free long term care up there, while means tests force tens of thousands of family homes to be sold south of the border.

English voters and taxpayers seem quite happy to put up with our Scottish rulers, Prime Minister Gordon Brown and Chancellor Alistair Darling, applying different fiscal regimes to different parts of the United Kingdom. "Yo ho ho!", we seem to say, as they grimly raise taxes in the south and cheerily spend them in the north. Or perhaps it is all an inevitable result of having a parliament in Edinburgh as well as London.

Speaking as a deracinated Jock, I have no wish to start a row with the rest of the Cowie clan just a few days before Hogmanay. Instead, I will merely risk irritating my wife by pointing out how this case demonstrates – once again – how differently pensioners are treated in the public and private sectors. There would have been no question of airily writing off or agreeing to forget the trivial sum of £126m had the good old taxpayer not been available to pick up the bill.

Steve Bee, head of pensions at – appropriately enough – Scottish Life, told me: "These pensioners are lucky that public sector schemes are not covered by the same legislation that governs private sector schemes, which are required by law to pursue any overpayment of more than £250.

"If a private sector pension failed to pursue the overpayment – or did so unsuccessfully – then a minimum 40pc unauthorised payment surcharge would be levied by HM Revenue & Customs on the member but that could rise to 55pc."

Over at wealth managers Hargreaves Lansdown, Tom McPhail – yes, another deracinated Jock, we really are everywhere – cites several cases where companies have pursued pensioners for overpayments and others where the Ombudsman has intervened on the side of compassion. He added: "But mistakes in the calculation of a few tens of thousands of pensions pale into insignificance when you consider this week's estimate by the Confederation of British Industry (CBI) that public sector pensions will cost taxpayers in future £1 trillion – or £1,000 billion – to deliver."

Regular readers will know that the explanation is these are final salary or defined benefit pensions, which are so expensive to fund that they are rapidly disappearing in the private sector. Because these public sector schemes are either inadequately funded or completely unfunded – that is, having insufficient or no money set aside to pay pensions in future – children who have not yet been born will have to pay more tax decades hence to deliver promises already made to people on the public payroll now.

Put like that, Bernard Madoff, the alleged fraudster arrested in New York this week, is nowhere near running the biggest Ponzi scheme ever; that dubious title would have to be awarded much closer to home. Just as he is alleged to have relied on payments in from new investors to pay out returns and promote a $50 billion (£33 billion) fund that scarcely existed, our Government continues to issue promises which it hopes future generations will honour. If the whole bill for public sector pension rights already accrued fell on today's taxpayers, it would amount to £32,000 per person.

I have been banging on about this scandal for more years than I care to remember but it is good to see the CBI doing its bit to raise awareness. When I called it a form of "financial apartheid" in a journalistic attempt to turn up the volume on a complex subject several years ago, I may even have been the first to do so. Either way, it was pleasing to see Conservative leader David Cameron use that phrase when he tackled the topic last month and said the two-tier system must end.

However, as my wife – a proud civil servant – never fails to remind me when I am reckless enough to stray onto this topic, many people working in the public sector do so for modest wages and risk-free pensions help to make up for that fact. Certainly, if Mr Cameron wishes to reduce their contractual rights in any way he would have to lead by example. MPs have some of the most lavishly-funded, index-linked, final salary schemes in existence and so it would be unwise to hold your breath.

Now I think about it, when I suggested to two senior Tories that they could demonstrate the difference between them and the Government by asking for Opposition MPs' pensions to be calculated on the same money purchase or defined contribution system which is rapidly becoming the norm for their constituents. Both MPs reacted in the same way. They laughed.

Here and now, the important point is that far too many people spend the final years of their lives in poverty. Many more will do so in future if current trends continue. Widespread and understandable cynicism about savings and investments rather misses the point that you can opt out of saving but you cannot opt out of growing old.

The Government must stop loading stealth taxes on savers – most outrageously the £5bn a year tax on retirement funds' dividend income but also the age allowance clawback and 10pc tax trap on trivial income from deposits, described here last week.

Means-tested benefits disguised as tax credits are a pointless paper chase which fail to reach millions of those who need them most. The simplest way forward is for all pensioners to be allowed to receive tax-free income from savings.

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Pension plans around the world are suffering from severe underfunding issues. As a result, there is now a full scale assault on pension benefits with sweeping reforms taking place in New York, Japan and everywhere in between.

We now have a full blown pension crisis around the world and the reckless behavior of many global pension funds over the last few years will cost future generations trillions of dollars.

Before you dismiss my accusation, go back and read some of my past entries on how the global Ponzi scheme is unraveling fast and the end of the great pension con job.

Over the last decade, global pension funds shoved trillions of dollars into alternative assets like private equity, real estate, hedge funds, commodities, infrastructure, timberland and anything else that was suppose to add "diversification benefits".

The party lasted for a long time, leading many pension funds to suffer from what Nassim Taleb calls the illusion of stability.

But now the music has stopped, deleveraging has hit all asset classes, including the private markets. Worse still, looming deflation threatens all pension plans:

Deflation will be the biggest risk for company pension schemes [and all pension schemes] , which have already seen their deficits soar, an industry expert has warned.

Mark Wood, chief executive of Paternoster, an insurer which buys out pension schemes from companies wanting to shift their liabilities, said very few firms knew how to cope with a deflationary environment. There has not been deflation in the UK for almost half a century.

Wood, the former chief executive of insurance and pensions giant Prudential, told Scotland on Sunday: "We're going to have a new problem next year – that will be deflation. I think we're going to have a sharp little burst of deflation which will provide pension schemes with quite an issue. The majority of schemes have carefully worked out what happens as inflation rises, but very few have thought about deflation."

Deflation will lower the overall value of schemes' assets, according to Wood, but companies will only have limited scope to reduce pension provision. "I think we'll see quite wide deficits as a result of deflation," he said.

Consumer price inflation is already starting to ease off, with the Office for National Statistics last week reporting it fell sharply to 4.1% in November, down from a peak of 5.2% in September and 4.5% in October.

Jonathan Loynes, an analyst with Capital Economics, said: "November's UK CPI figures are another step along the path which is likely to lead to the first bout of deflation in the UK economy for almost half a century."

Deflation will be the latest blow to pension schemes, which have already been hit hard by plummeting stock markets. Recently, Scotland on Sunday revealed that nearly £10bn had been erased from the value of the country's private sector schemes this year.

Wood said the economic downturn had affected the valuation of corporate bonds which form part of pension scheme assets. Valuations are down as analysts expect a number of companies to default on their interest payments. "Basically default risk has gone up. None of us can be entirely sure what the default rate will be next year, so we're bound to be more cautious in valuing bonds," he said.

He is recommending that companies considering a buyout for their pension scheme hold off until a more "temperate" market exists. Given the current volatility, he expects a quiet start for the buyout market in the first half of 2009, followed by a pick-up that will lead to more business than this year.

Deflation will deal a death blow to pension funds that got out of government bonds to invest in illiquid asset classes. It will also pulvarize the entire global financial system.

That is why you are seeing unprecedented quantitative easing and huge fiscal stimulus in the industrialized world.

But while the US and Japan are adopting identical policies of zero interest rates and quantitative easing, despite having opposite problems, success is not guaranteed:

It’s hard to understand how ZIRP (zero interest rate policy) and QE (quantitative easing) can apply to a country with low overall indebtedness and a current account surplus, like Japan, and yet be adopted by a country with high indebtedness and a current account deficit, like the US. But that seems to be the mysterious convergence occurring between the largest and second-largest economies in the world.

In the case of Japan, domestic observers feel little confidence that such measures will boost the economy. ZIRP and QE were not able to reverse deflation in the past, and it was exports that dragged Japan out of its recession from 2002 onwards, pushing the country to its longest post-war expansion (although at a modest annual rate of 2%).

Yet investors in the Japanese bond and stockmarkets are betting heavily that the Bank of Japan will lower its benchmark rate today, despite it already being a measly 0.3%. Interest rate sensitive bank and property stocks jumped yesterday, while bond yields also came down ahead of today's decision by the BOJ.

Akira Maekawa, chief economist at UBS, believes that a rate cut is not a foregone conclusion, given the BOJ's distaste for a policy that makes basic financial operations difficult. “The BOJ estimates that as interest rates move towards zero, they make money market operations difficult, since there is little point in banks lending to each other for free.”

Is it possible that ZIRP and QE could work better in the US? The Fed certainly appears fanatically committed to preventing the kind of adjustment that normally happens after a bubble: a contraction. The US is also acting faster and with greater firepower than in Japan, where the idea of reflating the economy through large deficits and a recapitalisation of the banks took many years to gain acceptance.

Jeffrey E. Garten, a Yale academic and former US government official, even called for additional expenditure of $4 trillion worldwide in a recent edition of Newsweek magazine. That is on top of up to $8 trillion spent on the bailout in the US alone, which accounts for around half of the country’s GDP.

Yet the experience of Japan does not give cause for optimism. UBS’s Maekawa writes in a recent report: “Realistically, the BOJ has no other policy options except QE, despite the potentially high cost of introducing QE and the very limited likely impact on the real economy.” He goes on to forecast the highest negative growth in 10 years for Japan, with 2009 GDP declining by 0.9%.

Maekawa believes the pessimistic BOJ position on QE is due to the fact that it “helps ease stresses in financial systems, but that it would do little to help negative prices turn positive or to re-energise a waning real economy. However, there is nothing left in the face of the increasing risk that conventional liquidity provision will be insufficient to overcome the unprecedented deleveraging-induced recessionary pressure.”

Richard Koo of the Nomura Research Institute in Japan and a leading historian of the Japanese experience, believes that QE and ZIRP didn’t work for the simple reason that when companies and individuals are rebuilding their balance sheets, there is no demand for loans. “With no one borrowing money, the liquidity supplied by the BOJ will simply sit in the system and will not add to the economy’s income stream,” he writes in his book Balance Sheet Recession.

Koo also disagrees with 'helicopter money’ for Japan – the policy related to QE where money is given directly to consumers and companies – because once they realise that everybody has received the same amount of money, it’s clear that nothing has changed.

The only consequence is that asset prices will rise to match to extra liquidity. Worse, people could lose confidence in the money and rush to change yen into a ‘harder’ currency. Interestingly, the reaction to the Fed’s interest rate cut to practically zero appears to partly bear Koo out, since the dollar declined sharply against the yen and other currencies on Thursday. However, US Treasury yields paradoxically came down as investors simultaneously sought a safe haven.

One way out of this strange and unprecedented situation is to adopt good old fiscal programmes. The biggest and most effective ‘fiscal programme’ in the US was World War Two, which was several magnitudes bigger than President Roosevelt’s New Deal and finally drove the US economy out of its slump. So maybe the wars in Afghanistan and Iraq will ironically end up saving the US economy, assuming they go on long enough.

Will fiscal stimulus and quantitative easing help stimulate the global economy? Let's hope so because if these measures do not work, deflation will wreak havoc on global pension funds and the global financial system for a very long time (possibly a decade or longer).

So the next time someone tells you the Madoff scandal was the greatest Ponzi scheme ever, please correct them and tell them that $50 billion is peanuts compared to the trillions global pension funds have lost and will continue to lose in the great "alternatives" pension debacle.