The Simple Economics of Funded and Unfunded Pension Systems

Most state pension schemes are financed on a pay-as-you-go (PAYG) basis, which means that taxes on the young are used to pay for the pensions of the retired generation. With private pensions, however, a fund of assets is built up and invested. Some countries such as Chile and Australia have moved to a mandatory funded pension system and the Conservatives in the U.K. have proposed to do the same with their Basic Pension Plus proposal. Other countries such as the U.S. and Sweden have built up a funded reserve to help ease the payment of pensions when the ‘baby boom’ generation retires. This article reviews the economic theories of funded and unfunded pension systems and examines the advantages and disadvantages of each type of system; these theories help to explain the current interest in funded systems as well as the difficulties associated with the transition towards them