What Is a Ponzi Scheme? History, Examples, vs Pyramid Scheme

Is Social Security a Ponzi Scheme?

Ponzi
Charles Ponzi around the time of his release from jail, Boston, Massachusetts, 1934. Photo by Archive Photos/Getty Images

Definition: Ponzi schemes are fraudulent investments. They always promise above-average returns and at first make good on these returns. This is because they use the principal investment from new investors to pay returns to the old investors. Ponzi schemes never make legitimate investments. Instead, they use all their resources to get new investors. Eventually, these schemes fall apart. They cannot keep recruiting enough new people to continue paying returns to the old investors.

 

Charles Ponzi

Charles Ponzi lured thousands of investors in the 1920s. He promised a 50 percent return in 90 days on profits made from international reply coupons. These coupons were slightly less in value in foreign countries. They could be redeemed for real stamps higher in value in the home country. The profits seemed plausible to gullible investors, but it would require millions of coupons to make any profit at all. Instead, Ponzi used the funds he acquired to pay off a few early investors in 45 days. This made his proposal believable. In a few months, he collected $20 million. He once received $1 million during a three-hour period.

The Ponzi scheme crumbled when he was unable to pay off later investors. By then, he had lost between $7-15 million and ruined six banks. The government charged him with mail fraud under the state and federal law. He received a prison sentence of five to nine years.

He jumped bail and proceeded to launch the charpon land syndicate in Florida where he sold real estate that was underwater.  Texas authorities kidnapped him and returned him to Boston. He was released in 1934. (Source: "Charles Ponzi," NNDB. "Ponzi Scheme," SEC. "​The Greatest Financial Scandals," Bloomberg.)

Examples

Bernie Madoff operated the longest-running Ponzi scheme. For 20 years, investors poured $17.5 billion into his "investment firm". He paid above-average returns using funds from new investors. The 2008 financial crisis brought his fraud into the light when investors tried to withdraw $7 billion. With a net worth of only $300 million, Madoff was unable to reimburse them. He pled guilty and is currently serving a 150-year sentence. His son, Mark Madoff, committed suicide only two years after the arrest of his father. He hung himself in his New York City home. His 2-year old son was asleep in the next room. Andrew Madoff died of cancer in September 2014.

Prior to his arrest, Madoff enjoyed a stellar reputation with the foundation of the NASDAQ as one of his accomplishments. The charges for the fraud did not extend to the other members of the Madoff family. His wife and two sons worked for related businesses in separate buildings. The courts allowed Ruth Madoff to keep $2.5 million. She now lives in a 989-square foot apartment in Connecticut. (Source: "Bernard Madoff Criticizes Court Trustee," USA Today, January 23, 2015.)

Chinese authorities announced the most recent example of a Ponzi scheme in February 2016 where one million investors lost $7.6 billion to Ezubao.

This online lending company promised 15 percent returns, which never happened. Instead, the 21 owners spent money from investors to run their company and buy luxury cars and houses. Ezubao operated from July 2014 to December 2015. (Source: "Biggest Ponzi Schemes in History," MSN Money, February 8, 2016.)

Is Social Security a Ponzi Scheme?

Social Security looks like a Ponzi scheme. Workers pay into the Social Security Trust fund. Despite the name, there is no trust holding these funds for them. Instead, the funds pay benefits to existing retirees. Once the paying workers are ready to retire, new funds will come from new workers.

People call social security a Ponzi scheme because the people who got in early are receiving more than they paid in. Baby boomers paid more payroll taxes than the contributions received by their parents.

This is not the case for retiring boomers. There will not be enough workers in the future to pay benefits to them when they retire. By 2030, Social Security will need to draw from the general fund to pay out benefits. That will create a budget deficit or a need for new taxes.

That means the government will force the next generation to pay for benefits. They have no choice. That's the difference between Social Security and a Ponzi scheme.

Difference Between Ponzi and Pyramid Schemes

Ponzi schemes are fraudulent investments. The participants believe they are putting their money to work in a real investment. Pyramid schemes are fraudulent multi-level marketing businesses. Participants understand that they must recruit new members to make money. Those at the top levels of the pyramid make money from the new recruits at lower levels. Sadly, those at the lower pyramid levels will never find enough new recruits to make money. They find they have wasted much time and money once the pyramid collapses. (Source: “Pyramid Schemes,” SEC. "Pyramid vs Ponzi Scheme: Which One Is Worse?" VOA, April 25, 2016.)

Most well-known MLM companies are not pyramid schemes. Examples include Amway, Meleleuca, and PrePaid Legal. Most of their customers are also not representatives of the company. This is the main difference between an MLM business and a pyramid scheme. Legitimate MLM businesses are good opportunities for people who want to learn how to run their own ventures. Here are six questions to ask anyone who invites you to join an MLM business.