Industry Voices

Barry’s Pickings Online: The End of PAYGO?

Michael Barry, president of the Plan Advisory Services Group, contemplates what will happen to the pay-as-you-go retirement systems as demographics change.

By PS | June 01, 2017
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PS-Portrait-Article-Barry-JCiardiello.jpgArt by J. CardielloPay-as-you-go (PAYGO) retirement systems were, for millennia, the way that retirement was financed. Admittedly, “retirement” before the second half of the 20th Century was less about sitting on a beach and more about disability and the inability—because of “old age”—of individuals to support themselves by working. And the “financing” of retirement was not really formalized until the adoption in Europe and then in the United States of systems of social insurance.

But before those formal, government-sponsored PAYGO retirement systems were put in place, the most obvious way people dealt with their “retirement” (a.k.a. disability) was to move in with their children (or other relatives). Which is just an informal version of PAYGO—the generation that is working pays, out of pocket, to support the generation that can no longer work.

Thus, what defines a PAYGO system is that individuals who are currently working take part of their current earnings and transfer it to those who can’t. As such, it’s a transfer between generations. It is not (and this is a really important point) a transfer across time. As a result, in a PAYGO system, you don’t need savings. What you need is a working generation that is productive enough that it can both support itself and its parents.

For the period from (say) 1850 to 2000, a number of demographic factors made PAYGO the ideal way to finance retirement. First, we could generally count on population growth to provide an increasing number of “current workers.” This was especially true in the 20th century (the heyday of government PAYGO retirement systems), when world population grew at an unprecedented rate. (In the U.S., increasing real wages also helped this process enormously.) Second, when most of these systems were put in place, at the end of the 19th and the beginning of the 20th centuries, life expectancy after retirement was relatively short. Third, at that time, child-raising costs (a dependency cost which also must be born by the working generation) were low (at least relative to what they are today).

PAYGO’s one great virtue is that it’s really simple to operate. You don’t have to save or invest anything. One generation simply writes checks to the other.

But it has two great flaws. First, it presents an adequacy problem. If the demographic algebra changes—if, for instance, the working generation is smaller than the retired generation—the system won’t work.

Moreover, because PAYGO depends entirely on an implicit compact between generations, the system will be stressed and may fail if the working generation simply finds the PAYGO burden too onerous—because, e.g., the period of retirement has increased (because of longer lifespans) or the burden of child-raising has increased. Or, even, the rate of population or wage increase is lower than expected.

Second, it presents a fairness problem. If everyone has the same number of children (or at least pays the child-raising costs of the same number of children), then the PAYGO burden is evenly distributed. But, obviously, that doesn’t happen. Consider that, in the United States, the “child-free-ness” rate has grown from one in 10 (in 1976) to one in five (in 2007). Who’s paying for the retirement of these “child-free” individuals? Someone else’s children.

NEXT: Population growth made PAYGO work