How Do Pay-As-You-Go Pension Plans Work?

A pay-as-you-go pension plan is a specific pension scheme where the benefits are directly tied to the contributions or taxes paid by individual participants. This contrasts with fully funded pension plans where the pension trust fund is not actively paid into by its future beneficiaries.

Understanding Pay-As-You-Go Pension Plans

Pay-as-you-go pension plans are sometimes referred to as "pre-funded pension plans." Both individual companies and governments can set up pay-as-you-go pensions; one of the best examples of a government scheme with pay-as-you-go elements is the Canada Pension Plan (CPP). 

The level of control exercised by individual participants depends on the structure of the plan and whether the plan is privately or publicly run. Pay-as-you-go pension plans run by governments may use the word "contribution" to describe the money that enters the trust fund. Still, these contributions are usually taxed at a set rate, and neither workers nor employers who contribute have any choice about if or how much they pay into the plan.

Choosing Your Own Deductions and Contributions

If your employer offers a pay-as-you-go pension plan, you likely get to choose how much of your paycheck you wish to be deducted and contributed toward your future pension benefits. Depending on the plan's terms, you can either have a set amount of money pulled out during each pay period or contribute the amount in a lump sum. This is similar to how several defined-contribution plans, such as a 401(k), are funded.

In many cases, you also have the option to select from a few different investment choices for your contributed pension money. This also means that you are assuming some of the investment risks for your pension, and your choices impact the benefits you receive when you retire. You do not get to determine where to place investments in a fully-funded pension plan.

Types of Pay-As-You-Go Pension Plans

• Government Plans: Government-provided pay-as-you-go pension plans do not usually offer a lot of options on the payout side, either. Beneficiaries are likely told when they are considered retired and given a few choices about receiving their payments in retirement.
• Private Plans: On the other hand, private pensions normally allow the beneficiary to elect a lump sum or lifetime monthly payment option upon retirement. If you elect a lump sum payment, the company cuts you a check for your entire pension amount. You assume complete control and are then responsible for managing your retirement assets yourself. If you elect for a monthly payment, your pension funds will probably be used to purchase a lifetime annuity contract that pays you a monthly balance and may even offer you the chance to earn interest over time.