Unfunded pension scheme

3 key takeaways

• Unfunded pension schemes rely on current workers’ contributions to pay current retirees’ benefits.
• These schemes do not have a pool of invested funds set aside for future pension payments.
• They are common in public sector pension plans and social security systems.

What is an unfunded pension scheme?

An unfunded pension scheme, or pay-as-you-go (PAYG) pension plan, operates by using the contributions from current employees to pay the pensions of current retirees. Unlike funded pension schemes, which invest contributions to build a reserve of funds for future benefits, unfunded schemes do not accumulate assets to cover future liabilities. Instead, the system depends on a steady flow of contributions from the workforce to meet its obligations.

Unfunded pension schemes are commonly found in public sector pension plans and social security systems, where the government guarantees pension payments and relies on tax revenues or mandatory contributions from current workers to fund these payments.

Key features of unfunded pension schemes

Unfunded pension schemes have several distinctive characteristics:

• Current funding: Pensions are paid out of current contributions from active workers rather than from accumulated and invested funds.
• No reserve funds: There is no pool of assets set aside to meet future pension obligations. The scheme relies on ongoing contributions to meet its liabilities.
• Intergenerational transfer: The scheme involves a transfer of wealth from the current working generation to the retired generation, which can create intergenerational equity concerns.
• Government backing: In many cases, particularly in public sector plans, the government guarantees the pension payments, ensuring that retirees receive their benefits regardless of the economic situation.

Examples of unfunded pension schemes

Unfunded pension schemes are common in various countries and sectors:

• Social security systems: Many national social security programs operate on a PAYG basis. For example, the U.S. Social Security system is an unfunded scheme where current payroll taxes fund the benefits of current retirees.
• Public sector pensions: Government employees in many countries, such as civil servants, teachers, and military personnel, often participate in unfunded pension schemes where their pensions are paid from current government revenues.

Implications of unfunded pension schemes

Unfunded pension schemes have significant implications for fiscal policy, economic stability, and intergenerational equity:

• Fiscal sustainability: The sustainability of unfunded pension schemes depends on the ratio of active workers to retirees. As populations age and the ratio declines, the financial pressure on the system increases, potentially leading to higher taxes or reduced benefits.
• Economic impact: Unfunded schemes can impact government budgets and national debt. Governments may need to allocate significant resources to cover pension obligations, affecting public spending on other services and investments.
• Intergenerational equity: The reliance on current contributions to pay for current retirees can raise concerns about fairness between generations, particularly if future generations face higher contribution rates or reduced benefits.

Understanding unfunded pension schemes is crucial for policymakers, workers, and retirees, as these schemes play a significant role in providing retirement security and affect broader economic and fiscal policies. For further exploration, topics such as pension reform, demographic trends, and fiscal policy provide deeper insights into the challenges and dynamics of unfunded pension systems.