What Is an Unfunded Pension Plan?
An unfunded pension plan is an employer-managed retirement plan that utilizes the employer’s current earnings to make pension payments as they become due. This approach contrasts with an advance funded pension plan, where an employer systematically sets aside funds in advance to cover future pension liabilities, including payments to retirees and their beneficiaries.
Key Takeaways
- Unfunded pension plans operate without dedicated assets, meaning that retirement benefits are paid directly from employer contributions.
- Also known as pay-as-you-go plans, these pension accounts can be established by either companies or governments.
- Many European government pension programs operate under unfunded pension schemes.
Understanding Unfunded Pension Plans
An unfunded pension plan, sometimes called a pay-as-you-go pension plan, is a retirement program offered by employers to provide salary replacement for employees upon retirement. In such a plan, employers manage financial requirements for the pension and make direct payments from current earnings as the need arises.
Many public pension systems provided by governments are based on this model, with benefits being paid directly from the taxes and contributions of current workers. Notably, several European countries operate largely unfunded pension systems where current taxes and social security contributions finance the benefits.
Hybrid vs. Fully Funded Systems
Some countries employ a hybrid pension system, where plans are partially funded. For instance, Spain’s Social Security Reserve Fund and France’s Pensions Reserve Fund are examples of hybrid systems. In Canada, the Canada Pension Plan (CPP) uses a partially funded mechanism with the CPP Investment Board managing the assets. Similarly, the U.S. Social Security system invests part of its funds in special U.S. Treasury Bonds to ensure partial funding.
In contrast, a fully funded pension plan has enough assets to cover all accrued benefits and meet all anticipated future payments to pensioners. This ensures the financial health of the pension plan by having the plan’s administrator predict and provision funds needed on an annual basis.
The Pay-As-You-Go Approach
Both private companies and governments can establish pay-as-you-go pensions. The degree of control participants have over an unfunded pension plan can vary based on the structure of the plan and whether it is privately or publicly managed.
For government-run unfunded pensions, contributions are typically collected through taxes at a fixed rate, offering little to no flexibility for workers and employers regarding both participation and contribution amounts. On the other hand, private pay-as-you-go pensions often grant participants some control over their contributions.
In a private pay-as-you-go pension plan, participants may be allowed to choose the percentage of their paycheck to be deducted and contribute to their future pension benefits. Depending on specific plan terms, participants can opt to have contributions deducted periodically or as a lump sum, similar in approach to various defined-contribution plans such as 401(k) plans.
Related Terms: advance funded pension, hybrid pension plan, fully funded pension, accrued benefits, defined-contribution plans, Social Security.
References
- Gobierno de España, Ministerio de Inclusión, Seguridad Social, y Migraciones. “Reserve Fund”.
- Fonds de Reserve. “The FRR’s Mission”.
- Government of Canada. “CPP Retirement Pension: Overview”.
- Social Security Administration. “What Are the Trust Funds?”
