What Is a Pyramid Scheme? How Does It Work?

A pyramid scheme is a fraudulent and unsustainable investment pitch that relies on promising unrealistic returns from imaginary investments. The early investors actually get paid those big returns, which leads them to recommend the scheme to others. Investors' returns are paid out of the new money flowing in. Eventually, no new investors can be found and the pyramid collapses.

In a variation of the pyramid scheme, investors at each level charge initiation fees that are paid by the next layer of investors. A portion of those fees is paid on to those in the top layers of the pyramid. Eventually, no one is left to recruit. The pyramid collapses.

Often called pyramid scams, these operations are illegal in the U.S.

How Pyramid Schemes Work

Pyramid schemes are so named because their compensation structures resemble a pyramid. The scheme starts with a single point on top where the original members exist and becomes progressively wider toward the bottom as people are recruited by every level of recruits.

Say that the scheme's founder Mike sits alone at the top of the pyramid. He recruits 10 people with some promise of a big return on their money. They're represented by the level directly below him on the pyramid.

Each of those new, 10 members, or participants, pays Mike a certain fee to take part in the opportunity he's offered them. Then, each of those members is encouraged to recruit 10 more members, for a total of 100 members.

Now each of those 100 new recruits must pay fees to the tier-two recruiters, who must send a percentage of their earnings up to Mike. This recruitment and payment cycle repeats over and over again for as long as possible. As it does, money continues to flow upward to those in the levels above.

The emphasis in pyramid schemes is on recruiting new members. Seldom is the sale of any product or service actually involved, though it may have been implied to attract recruits. There is no identifiable source of income other than that coming from those recruited.

According to the hard-sell pitches made at recruitment events, those bold enough to take the pyramid plunge will receive substantial cash from the recruits below them. However, in practice, the prospective member pools tend to dry up over time. By the time a pyramid scheme invariably shuts down, the top-level operatives may walk away with loads of cash while the majority of lower-level members are left empty-handed.

Types of Pyramid Schemes

Multi-Level Marketing Pyramid Scheme

Multi-level marketing (MLM) is a legal business program. This business model involves the sale of actual goods or services by distributors or participants in the MLM. Distributors get paid for those products and services of the MLM that they sell. They can also receive income from sales made by distributors that they've recruited and from people those recruits then bring in.

However, some pyramid schemes disguise themselves as MLMs. The Federal Trade Commission warns people to take note of, and avoid, MLM promoters who:

• Make extraordinary claims of enormous earning potential
• Try to persuade people that recruiting others is where the real money lies
• Pressure people to get involved without learning more about the company
• Make it clear that an opportunity will be lost unless people get in immediately

Another warning sign is seeing existing distributors who continue to buy products that they can never sell so that they can qualify for some kind of reward.

Chain Emails

Chain emails persuade naive recipients to donate money to everyone listed within an email. After making their donations, the donors are invited to delete the first name on the list and replace it with their own.

They're instructed to forward the email along to their own groups of contacts, in the hope that one or more of them will send cash their way. In theory, recipients will keep collecting donations until their name is deleted from the list.

Ponzi Schemes

Ponzi schemes are investment cons that work by robbing Peter to pay Paul. They may not necessarily adopt a pyramid scheme's hierarchical structure but they do promise high returns to existing investors.

Ponzi schemes typically involve a single, initial investment only from investors. Then, those investors wait for the promised return on their money. That is provided by new money from other investors persuaded to take part by the leader of the scheme. Most Ponzi participants end up losing everything when money for this sort of scheme dries up.

Investment advisor Bernard Madoff, arguably the most notorious Ponzi scheme artist, was sentenced to 150 years in prison for operating a multibillion-dollar Ponzi scheme. Madoff convinced many high-profile individuals to invest with him, falsified portfolios and relevant paperwork, and paid off early investors with money received from later investors. Most investors lost everything. Madoff died in prison on April 14, 2021.

Example of a Pyramid Scheme

In recent years, the SEC filed charges to stop a pyramid scheme masquerading as an MLM program. The company, which was called CKB, solicited investors all over the world, and in particular, focused on Asian-American communities in New York and California.

The SEC alleged that CKB posed as a very profitable MLM company that made money selling online educational courses for children. Unfortunately, this classic pyramid scheme involved little or no retail sales. Its only source of revenue was the money it procured from new investors.

How Pyramid Schemes Collapse

Pyramid schemes are viable as long as new, paying participants continue to buy in. The pyramid base must continue to grow. When the pool of available and willing participants disappears, the entire structure collapses.

It's impossible for pyramid schemes to function for long terms. People will invariably lose their money. Even high-level early participants may lose money near the end, due to waiting periods that delay payments from lower level recruits. 

The Bottom Line

Pyramid schemes are illegal in many countries. The pyramid model of profiting from a network of contacts often forces individuals to recruit their family members, friends, and acquaintances. This ultimately can strain relationships. Investors would be wise to avoid such schemes.