Unfunded Pension Plan: What it Is and How It Works

Key points

• An unfunded pension plan (also called pay-as-you-go) pays retirement benefits from current employer or government income rather than from assets set aside in advance.
• Many public pension systems—especially in Europe—operate on an unfunded basis, with benefits paid from current taxes and contributions.
• Some systems are partially funded (hybrid) or fully funded; each approach has different implications for sustainability and risk.

What is an unfunded pension plan?

An unfunded pension plan is a retirement arrangement where benefits are paid out of current income flows (employer receipts, worker contributions, or tax revenue) instead of from a dedicated investment pool. There are no accumulated assets earmarked to meet future liabilities; payments to retirees are financed as they become due.

How it works

• For governments: Retirement benefits are typically paid from current tax revenue and social contributions. Workers and employers usually have little or no choice over contribution amounts—rates are set by law or policy.
• For private employers: A pay-as-you-go option can allow employees to elect contribution amounts from their paychecks or make lump-sum contributions, similar in mechanics to defined-contribution plans like 401(k)s.
• In both cases, the plan relies on ongoing inflows to meet outflows, so the balance between contributors and beneficiaries matters.

Examples and mixed models

• Many European national pension systems are unfunded, paying benefits directly from current taxes and contributions.
• Some countries use hybrid or partially funded approaches: Spain’s Social Security Reserve Fund and France’s Pensions Reserve Fund are examples.
• Canada’s Canada Pension Plan (CPP) is partially funded and managed by an investment board. The U.S. Social Security system is partially funded through special Treasury securities.

Unfunded vs. fully funded (and hybrid)

• Fully funded: A plan has sufficient assets set aside and invested to meet all accrued benefits when due. Funding status can be measured and projected annually.
• Unfunded (pay-as-you-go): No assets are accumulated; benefits are paid from current resources.
• Hybrid/partially funded: Combines elements of both—some reserves or investments are held while current contributions also finance benefits.

Advantages and drawbacks

Advantages
* Lower immediate funding cost for sponsors since benefits are paid as they arise.
* Simpler administration when no asset management is required.

Drawbacks / Risks
* Sustainability depends on demographic and economic factors (e.g., worker-to-retiree ratios, wage growth, tax revenue).
Vulnerable to political and fiscal pressure—benefits can be reduced or taxes/contributions increased if revenues fall short.
Lacks a dedicated asset buffer to smooth shocks or investment returns.

Who controls contributions and benefits?

• Public plans: Contribution rates and benefit rules are typically set by legislation; individual contributors have little control.
• Private plans: Plan design may allow participants to choose contribution levels or timing, subject to plan rules.

Conclusion

Unfunded pension plans finance retirement benefits from current income rather than from assets accumulated in advance. They are common in public systems and can work efficiently when demographic and fiscal conditions are stable. However, because they lack reserves, they carry sustainability risks that often prompt reforms, partial funding, or the creation of reserve funds to improve long-term viability.