What Is Pay-As-You-Go Pension Plan?

A pay-as-you-go pension plan is a retirement scheme 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 on whether they want a higher return by investing in a more risky fund or a safer fund which provides steady returns.

This is in contrast to fully funded pension plans where the pension trust fund is not actively paid into by its future beneficiaries. Pay-as-you-go pension plans are sometimes referred to as "pre-funded pension plans."

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 examples of a government scheme that has pay-as-you-go elements is the Canada Pension Plan, or CPP. 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 towards your future pension benefits. Depending on the terms of the plan, 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.

When retirement age comes for the beneficiary of a pay-as-you-go pension plan, they can choose to either receive the benefits in a lump sum or as a lifetime annuity where the benefits are spread in monthly payments throughout the beneficiary's lifetime. This is different from a fully funded (or defined-benefit) pension where the company fully funds, manages and distributes the benefits at retirement.

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, but usually these contributions are taxed at a set rate and neither workers, nor employers, who contribute have any choice about if or how much they pay in to the plan. Private pay-as-you-go pensions, however, offer their participants some discretion.

Key Takeaways

  • A pay-as-you-go pension plan requires individuals to fund their own retirement savings accounts with a portion of their earned income over time.
  • These type of retirement plans may be set up by individuals, companies, or governments, but all of them lack retirement income guarantees or defined benefits.
  • 401(k) plans and other defined-contribution retirement accounts are examples of pay-as-you-go pensions.

Pay-As-You-Go Pension Plans and Political Risks

One of the main problems faced by pay-as-you-go pension systems is the inherent political risks. These risks refer to decisions made by politicians, which are tied to their traditionally short planning horizons of often only 4 years – a time horizon that is clearly far less than that of a pay-as-you-go pension system. Pay-as-you-go pension systems tend to require periodic adjustments because of demographic and economic uncertainty, and often times, those adjustments depend on discretionary legislation, which may not always have the best long-term interests of pay-as-you-go contributors and beneficiaries. These political risks are very real.

Government-provided pay-as-you-go pension plans do not usually offer a lot of options on the payout side, either. It is likely that beneficiaries are told when they are considered to be retired and given a few choices about how to receive their payments in retirement. Private pensions, on the other hand, 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.