Pay-As-You-Go System (Umlagesystem)

Concept

In a pay-as-you-go system, the contributions currently received from active contributors are used directly to finance the current pension benefits paid to current retirees or beneficiaries, without building up an individual capital reserve set aside for the future entitlements of each individual contributor. A pay-as-you-go system is thus based on an intergenerational contract, under which each generation of the working population finances the pension benefits of the preceding generation.

Distinction from the Funded Approach

Unlike the funded approach, under which an individual policy reserve is accumulated and invested for each insured, from which the future benefit is financed, the financial stability of a pay-as-you-go system depends significantly on the numerical ratio between active contributors and beneficiaries; an unfavorable demographic development, with a declining number of contributors per beneficiary, therefore represents a key risk to the long-term sustainability of pay-as-you-go financed systems.

Areas of Application

The pay-as-you-go system is used primarily in statutory or social pension insurance and in certain forms of occupational pension provision, while private life and annuity insurance and funded occupational pension schemes are predominantly organized under the funded approach; some pension systems combine both financing methods in order to balance their respective advantages and disadvantages.