Pension Insurance: Difference between PAYG and Capital Covered Insurances

Different pension insurances are based on different models. There is a big difference between PAYG (pay as you go) and funded (capital covered) models. I would like to explain this fundamental difference here.

Pay-As-You-Go Pension Insurance

An example of a pay-as-you-go pension insurance is the statutory pension insurance. The principle of this pension insurance is the following: The younger generation, which is currently working, pays into the pension fund. The older generation, which is currently receiving a pension, gets this money.

This principle is called a generation contract, a contract between the younger and the older generation. The younger generation, who are paying now, may hope that later, if they themselves belong to the older generation, will be funded by the then younger ones.

You call this kind of old-age pension "pay-as-you-go pension insurance", since the money, which is taken today by the younger ones is passed on directly to the older ones (thus transferred).

Disadvantages: Of course, this model works only if there is a balance between the depositors and recipients. As our society grows older and fewer children are born at the same time, the question inevitably arises as to how long this generational contract can still go well.

Capital-Covered Pension Insurance

Another way is the capital covered or funded pension insurance. In this model, the money that is deposited is not immediately paid back to the pensioners and instead invested and managed.

For example, in life insurances, equity funds, bonds or other securities that promise to increase in value.

The pension is finally paid from the hopefully then increasing capital.

Disadvantages: The problem with this model is that while it is immune to demographic imbalances, it depends on a functioning capital market. In times of lower interest rates or a stock market crash, such a calculation can not quickly rise..