Pay-as-you-go

Pay-as-you-go (PAYG) is a funding method where current payments and contributions are used to cover current costs, with nothing or very little being saved or invested for the future. Think of it as a direct pipeline rather than a reservoir. In the world of investment and personal finance, this term most famously describes the massive public pension and healthcare systems in the Western world, such as Social Security and Medicare in the United States or the state pension systems across Europe. Under a PAYG system, the taxes paid by today's workers are not put into a personal savings account with their name on it. Instead, that money is immediately transferred to pay the benefits of today's retirees and other beneficiaries. This system is often referred to as a “generational contract”—a social promise that the current generation will support its elders, with the expectation that the next generation will do the same for them. It stands in stark contrast to a “fully funded” model, like a private pension or a 401(k), where contributions are invested to grow and pay for one's own future benefits.

The mechanics of a Pay-as-you-go system are, on the surface, beautifully simple.

1. Step 1: The government collects mandatory contributions from the current workforce, usually in the form of payroll taxes (like FICA taxes in the US).
2. Step 2: This pool of money is immediately paid out to those currently eligible for benefits—retirees, the disabled, and other groups covered by the program.
3. Step 3: The cycle repeats. When today's workers eventually retire, their benefits are supposed to be funded by the taxes of the generation that follows them.

This differs fundamentally from the two main types of private retirement plans. In a Defined Benefit Plan, a company promises a specific payout and must invest funds to ensure it can meet that future promise. In a Defined Contribution Plan, you and your employer contribute to an account that is invested, and its final value determines your retirement wealth. In both private cases, the money is saved and invested. In a PAYG system, the money is transferred.

A value investor looks for durability and a margin of safety. From this perspective, PAYG systems raise several red flags because their long-term viability is built on shifting sands rather than a solid foundation of assets.

The fatal flaw of PAYG systems is their extreme vulnerability to demographics. These programs were created in the mid-20th century, a time of high birth rates and shorter life expectancies. In the US in 1950, there were over 16 workers paying into Social Security for every one person collecting benefits. The math was easy. Today, the situation is reversed. People are having fewer children and living much, much longer. The worker-to-beneficiary ratio has plummeted to less than 3-to-1 and is projected to fall closer to 2-to-1 in the coming decades. With fewer workers paying in and more retirees drawing benefits for a longer time, the system is under immense, and mathematically certain, financial strain.

It's a provocative question, but one worth asking to understand the financial mechanics. A PAYG system is not a Ponzi Scheme in the legal sense. Ponzis are fraudulent, illegal, and designed to enrich their creators, whereas public pensions are transparent government programs designed for social welfare. However, the comparison is often made because the cash flow structure is eerily similar. Both systems require an ever-expanding base of new contributors to pay off the earlier ones. When the flow of new money slows down—as it inevitably does in a Ponzi and as it is now doing in PAYG systems due to demographic shifts—the model becomes unsustainable. The analogy helps illustrate the core problem: PAYG systems don't create wealth through investment; they merely redistribute it, relying on a constant stream of new participants to keep the promise afloat.

This brings us to the terrifying concept of unfunded liability. This is the difference between the total value of the benefits the government has promised to pay in the future and the tax revenue it can realistically expect to collect to pay for them. For systems like Social Security and Medicare, this number is in the tens of trillions of dollars. Think of it this way: It's like having a mortgage for a €1,000,000 mansion but only having a realistic career plan that will earn you €300,000. That €700,000 gap is your unfunded liability. You've made a promise you can't keep without a dramatic change. For governments, that change must come in a few, equally unpalatable forms.

Understanding the fragility of Pay-as-you-go systems isn't about being cynical; it's about being a realist and taking control of your financial destiny.

• Treat State Pensions as a Bonus, Not a Foundation. It is extremely unwise to build your retirement plan with a government pension as its cornerstone. Assume you will receive something, but it may be less than promised, or you may receive it much later in life. Any benefit you get should be the gravy, not the main course.
• Expect the Rules to Change. To close the funding gap, politicians have only a few levers to pull. You should fully expect some combination of the following in your lifetime:
  1. Higher payroll taxes for you and your children.
  2. An increase in the official retirement age.
  3. A reduction in the monthly benefit amounts.
  4. “Means-testing,” where wealthier retirees (i.e., those who saved diligently) receive reduced or no benefits.
• Become Your Own Pension Manager. This is the ultimate takeaway for a value investor. The only person you can truly rely on for your retirement is yourself. The solution is to build your own fully funded system. Consistently save and invest in tax-advantaged accounts like an IRA in the US, a SIPP in the UK, or other private investment vehicles. By buying and holding productive assets—great businesses, real estate, etc.—you are building a personal reservoir of wealth that is not dependent on demographic trends or political promises. This is financial self-reliance.