Pension Financing

There are various ways in which a pension may be financed.

Funded status

In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes. This method of financing is known as Pay-as-you-go. It has been suggested that this model bears a disturbing resemblance to a Ponzi scheme.

In a funded defined benefit arrangement, an actuary calculates the contributions that the plan sponsor must make to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan. In the United States, private employers must pay an insurance-type premium to the Pension Benefit Guaranty Corporation, a government agency whose role is to encourage the continuation and maintenance of voluntary private pension plans, provide timely and uninterrupted payment of pension benefits.

Defined contribution pensions, by definition, are funded, as the "guarantee" made to employees is that specified (defined) contributions will be made during an individual's working life.

Local or universal plans

Because any dollar of savings by any one person in the economy means a dollar of borrowing by another person (all financial assets in the economy net to zero at all times, but real assets do not), any universal system of pensions cannot save in the conventional way. Therefore, if the United States were a true autarkic economy, then any universal pension system must be pay as you go because the food, clothes and services that someone aged 25 year today would need in 40 years would be when he is age 65 would be produced 40 years later. Storing money or financial assets today represents current claims on current production. But a system of prefunding would enable the accounting of such a system to work, given that real savings in the form of capital investments would have made the economy more productive in the future.

However, once we release the assumption of universality by say allowing for foreign investments -- the average age in Mexico is under 16 -- we can perform some pre-funding. The extent of possible pre-funding could be gagged by the current account or trade deficit or surplus.

Current challenges

A growing challenge for many nations is population ageing. As birth rates drop and life expectancy increases an ever-larger portion of the population is elderly. This leaves fewer workers for each retired person. In almost all developed countries this means that government and public sector pensions could collapse their economies unless pension systems are reformed or taxes are increased. One method of reforming the pension system is to increase the retirement age. Two exceptions are Australia and Canada, where the pension system is forecast to be solvent for the foreseeable future. In Canada, for instance, the annual payments were increased by some 70% in 1998 to achieve this. These two nations also have an advantage from their relative openness to immigration. However, their populations are not growing as fast as the U.S., which supplements a high immigration rate with one of the highest birthrates among Western countries. Thus, the population in the U.S. is not aging to the extent as those in Europe, Australia, or Canada.

Another growing challenge is the recent trend of businesses purposely under-funding their pension schemes in order to push the costs onto the federal government. Bradley Belt, executive director of the PBGC (the Pension Benefit Guaranty Corporation, the federal agency that insures private-sector defined-benefit pension plans in the event of bankruptcy), testified before a congressional hearing in October 2004, “I am particularly concerned with the temptation, and indeed, growing tendency, to use the pension insurance fund as a means to obtain an interest-free and risk-free loan to enable companies to restructure. Unfortunately, the current calculation appears to be that shifting pension liabilities onto other premium payers or potentially taxpayers is the path of least resistance rather than a last resort.”