What Is a Pay-As-You-Go Pension Plan?
A pay-as-you-go pension plan is a retirement arrangement where the plan beneficiaries decide how much they want to contribute, either by having the specified amount regularly deducted from their paycheck or by contributing the desired amount in a lump sum. A pay-as-you-go pension plan is similar to a 401(k). The employee can choose among the various investment options and decide whether they want a higher return by investing in a more risky fund or a safer fund that provides steady returns.
This is in contrast to fully funded pension plans, or defined-benefit plans, where the pension is funded by the employer rather than by its future beneficiaries. Pay-as-you-go pension plans are sometimes referred to as "pre-funded pension plans."
- A pay-as-you-go pension plan requires individuals to fund their own retirement savings accounts with a portion of their earned income.
- Pay-as-you-go pension plans, unlike fully funded or defined-benefit plans, don't guarantee how much money you'll receive at retirement.
- 401(k) plans and other defined-contribution retirement plans are funded in a manner similar to pay-as-you-go pensions.
How Pay-As-You-Go Pension Plans Work
Both individual companies and governments can set up pay-as-you-go pensions. One of the best-known examples of a government-run plan that has pay-as-you-go elements is the Canada Pension Plan (CPP).
If the company you work for offers a pay-as-you-go pension plan, you will likely get to decide how much money you wish to have deducted from your paycheck and invested toward your future pension benefits. Depending on the terms of the plan, you can either have a set amount of money pulled out each pay period or contribute the amount in a lump sum. This is similar to how defined-contribution plans, such as a 401(k), are funded.
When the beneficiary of a corporate pay-as-you-go pension plan reaches retirement age, they can often choose to receive their benefits either in a lump sum or as a lifetime annuity, where benefits will be paid out monthly for the rest of the beneficiary's life.
However, 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 goes into the trust fund, but usually, these contributions are based on a set tax rate, and neither workers nor their employers may have any choice about whether or how much they pay into the plan. Private pay-as-you-go pensions, in contrast, generally offer their participants greater flexibility.
When you retire, you may have a choice of receiving your pension in a single lump sum or monthly payments for life.
One of the main problems faced by government-run pay-as-you-go pension systems is their inherent political risks. Such plans are subject to decisions made by politicians, who may be limited by their traditionally short planning horizons, often of four years or less—a time horizon that's far shorter than a pay-as-you-go pension system may require. Pay-as-you-go pension systems also tend to need periodic adjustments because of demographic and economic uncertainty. Often, those adjustments must be made through discretionary legislation, which may not take into account the best long-term interests of pay-as-you-go contributors and beneficiaries.
Government-provided pay-as-you-go pension plans usually do not offer a lot of options on the payout side, either. In general, beneficiaries are told when they are considered to be retired and given just a few choices about how to receive their payments in retirement.
Private pensions, on the other hand, normally allow the beneficiary to elect either a lump-sum distribution or lifetime monthly income upon retirement. If you elect a lump-sum payment, the plan administrator cuts you—or a financial institution you designate—a check for your entire pension amount. You assume complete control and are then responsible for managing your retirement assets yourself. If you elect a monthly payment, the administrator will likely use your pension assets to purchase a lifetime annuity contract that will pay you monthly income and may continue to earn interest over time.