A pay-as-you-go pension plan is a retirement plan that uses current payments to fund pension benefits. Contributions are typically made in one of two ways: through your own contributions or through others’ current contributions. Either way, the funding is made through regular contributions, not at once.
Learn more about what pay-as-you-go pension plans are, how they work, and about the different ways they may be funded. Understand the pros and cons of pay-as-you-go pension plans to help you determine if they’d be a good retirement savings tool for you.
Definition and Examples of Pay-As-You-Go Pension Plans
A pay-as-you-go pension plan is an employer-sponsored retirement plan that is funded with ongoing regular payments instead of an initial lump sum that is invested toward retirement goals. An employee's pension may be funded with either regular contributions during their employment years or from regular current contributions.
Similar to a 401(k), a pension plan is established and maintained by an employer. However, unlike a 401(k), pension plans are more commonly defined benefit plans (as opposed to defined contribution plans). That means that the payments an employee will receive in retirement are determined in advance.
Then, the employer (or employee) makes regular contributions to the fund that will eventually provide retirement benefits. With defined benefits in public pension systems, contributions from current employees fund current benefits for retired employees.
Then, employees typically receive defined benefits as regular monthly payments in their retirement years. They may also have the option of taking a lump-sum distribution.
With defined contribution plans like 401(k)-type plans, the number of regular contributions are determined in advance, not the final benefit, which is undefined. With these pay-as-you-go plans, participants and/or employers make specific payments to fund future retirement benefits.
Examples of Pay-As-You-Go Pension Plan
Pay-as-you-go pension plans are designed to help employees have enough money to fund their retirement.
For example, an employer may provide a pension plan that promises a certain amount of monthly income that the employee can start to accept at a certain age. It may offer $500 per month once the employee is 60 years old. Or, a company may define a pension plan’s retirement benefits according to a specific formula that takes into account factors like the number of years an employee has worked and the amount they have earned.
Usually, with pension plans, employers make contributions. Although employees may also be required to contribute, or they may have the option to contribute.
With defined contribution pension plans, an employee (or employer) may agree to contribute a certain amount of each paycheck toward the benefits. For example, a 22-year-old who wants to save $1 million for retirement may have 15% taken out of each paycheck and put into a retirement account, which would be using a “pay as you go” strategy toward their goal.
The benefits you receive in retirement from a defined contribution plan would depend on how much you have contributed and how those investments have performed.
Pros and Cons to Consider
A pay-as-you-go pension plan can provide employees with the benefits they need to fund a retirement.
With defined benefit plans, you can plan for a specific amount of income during your retirement years. So, these plans can offer predictability. Typically, employers contribute to defined benefit pension plans, although employees may also be required to (or have the option to) contribute.
Depending on how they are structured, pay-as-you-go systems do have some downsides to consider. Private-sector pension plans by law must be federally backed through the Pension Benefit Guaranty Corporation (PBGC), but retirees won't necessarily receive the same retirement payments if the PBGC has to take over.
However, incoming contributions that are intended to fund current benefits in some pay-as-you-go systems could potentially fall short, Russ Kamp, managing director at asset/liability management firm Ryan ALM, told The Balance in an email.
How Do Pay-As-You-Go Pension Plans Work?
A pay-as-you-go pension plan works by using contributions made over time to fund retirement benefits instead of using an existing sum of money.
Benefits for retired employees may be funded with regular contributions from current employees or from regular contributions made throughout the employee’s working years.
With ongoing contributions made at regular intervals, investments may benefit from dollar-cost averaging, which can reduce risks.
- Pay-as-you-go pension plans involve putting money into a retirement plan over time with regular contributions instead of all at once.
- Typically, pension plans are defined benefit plans, meaning the amount you receive in retirement is defined in advance.
- Other types of pension plans include defined contribution plans, which are similar to how 401(k)s work with benefits depending on the number of contributions made.