Question

Algebraic Look at the Result of Demographic Changes Under a Pay-as-You-Go system

A) Please explain the following formula

t=(B/W)*(R/L)

t = B/W × R/L = the average replacement rate × the dependency ratio

t = total benefits paid
B = the average benefit
R = the number of recipients
W = taxable wages
L = the number of workers

B) What are the main differences between a pay-as-you-go (PAYG) pension system and capital-funded pension system?

C) What is the major problem of a PAYG system? Please explain it in a few sentences and the formula above.

D) What is a major problem of capital funded pension systems?   

Answer 1

a. Total benefits paid= ( Average benefits paid X the number of recipients ) / Taxable wages X number of workers

This means its the ratio of a pension to its liabilities.

b.

• A pay-as-you-go pension plan requires individuals to fund their own retirement savings accounts with a portion of their earned income whereas in the capital funded pension plan, pension is funded by the employer rather than by its future beneficiaries.
• Pay-as-you-go pension plans, unlike capital funded or defined-benefit plans, don't guarantee how much money you'll receive at retirement.

c. All the countries are maturing now ie Old age dependency ratio is increasing. Dependency on PAYG system is not suitable.

For countries that rely on a pay as you go (PAYG) pension system - whereby current workers finance current pensions - the status quo is clearly unsustainable without action.

If no action is taken, two options are possible: there will have to be an increase in the contributions of the economically active or, alternatively, a reduction in the level of benefits for retirees. Or maybe both

d. There is a risk of underfunding in the capital funded pension plan. The funding ratio can be below 1 which means that pension fund does not have sufficient means to pay all future obligations to those who participate.

• Underfunding means that pension payout liabilities exceed the assets a company has to cover those payouts; the company must increase its contribution to its pension portfolio—usually in the form of cash.
• It can be difficult to determine whether underfunding is happening because pension liabilities are for future payouts and companies may make overly optimistic assumptions about long-term rates of return on investments.