ABSTRACT
There are two basic ways of funding defined pension benefits: pay-as-you-go and advance funding (also called prefunding), as discussed in Chapter 1. Compared with advance funding, pay-as-you-go funding has two key disadvantages: escalating pensions cost and lack of investment income. First, since the ratio of retirees to active members of a pension plan tends to increase with the aging of population, pay-as-you-go leads to escalating pension cost in the future and puts tremendous pressure on the plan sponsor’s budget. Second, since no funds are set aside and invested, no investment income is earned. As investment income is a far more important source of funding over time to pay for pension benefits, a lack of investment income will lead to a much greater employer and employee pension contribution over time compared to advance funding. Even if pay-as-you-go can be less costly than advance funding in the short run, it can be far more expensive in the long run. Because of these major disadvantages, almost all public pension plans are now prefunded.
