What is a pension and why do we need one?
Think of your life as a timeline. As a child you use money but do not earn it. As an adult you work and earn. In old age you stop working. This is the life course.
When you retire, your salary stops. But you still need food, a home and medicine, maybe for 20 years or more. A pension is a regular income paid to you after you retire.
The idea is to move money from your working years to your old years. Economists call this consumption smoothing: keeping your living standard steady over your whole life.
Pay-as-you-go: one generation pays for the other
In a pay-as-you-go (PAYG) system, workers pay contributions or taxes today. The government uses that money at once to pay pensions to people who are retired today. Nothing is saved up in a pot.
It works like a promise: you pay for your parents now, and your children will pay for you later. Many state pensions work this way.
- Good: pensions start at once for the old; they can rise with wages.
- Risk: it depends on having enough workers for each retiree.
Funded pensions: your own pot that grows
In a funded system, money is saved in a pot for each person (or for a group). The pot is invested in things like shares and bonds and earns a return. The return is added to the pot, and next year that grows too. This is compound interest.
Example: save 100 a month at 5% a year for 40 years. You pay in 48,000. The pot grows to about 152,000. Two thirds of it is growth.
Two ways to promise a pension
- Defined benefit (DB): the pension is fixed by a formula, for example a share of your final salary. The employer carries the risk.
- Defined contribution (DC): the amount you put in is fixed; what you get depends on how the investments did. You carry the risk.
Ageing populations, pensions and public debt
People now live longer, and families have fewer children. So the share of old people grows. We measure this with the old-age dependency ratio: the number of people aged 65+ for every 100 people of working age.
In many rich countries there were about 4 workers per retiree some decades ago; this is falling towards 2. For PAYG this means a hard choice:
- raise contributions or taxes on workers,
- lower pensions,
- raise the retirement age, or
- let the government borrow, which adds to public debt that future taxpayers must repay.
This is why pensions are also a question of fairness between generations.
The three pillars and retirement planning
Most countries mix three pillars:
- State pension: a basic income for all, often PAYG and paid from taxes.
- Workplace pension: the employer and worker both pay in (in India, the Employees' Provident Fund, EPF).
- Private savings: your own choice, such as a personal pension plan, India's National Pension System (NPS) or the Public Provident Fund (PPF).
Planning tips: start early, save a fixed share of every salary, keep costs low, spread risk over many investments, and take more safety as you get close to retiring. Inflation (rising prices) means a pension must grow to keep its value.
Key formulas and definitions
- Pension = income paid after retirement
- Pot after n years ≈ yearly saving × [(1 + r)^n − 1] / r × (1 + r)
- Old-age dependency ratio = (people aged 65+ ÷ people aged 15–64) × 100
- Workers per retiree = working-age people ÷ retired people
- PAYG balance: contributions of workers = pensions paid to retirees
- Real return ≈ nominal return − inflation
Worked examples
1. A country has 60 million people aged 15–64 and 15 million aged 65+. Find the old-age dependency ratio and the workers per retiree.
Ratio = 15 ÷ 60 × 100 = 25 (25 older people per 100 of working age). Workers per retiree = 60 ÷ 15 = 4.
2. In a PAYG system, each retiree gets 1,000 a month. There are 4 workers per retiree. How much must each worker pay a month? What if it falls to 2 workers per retiree?
With 4 workers: 1,000 ÷ 4 = 250 each. With 2 workers: 1,000 ÷ 2 = 500 each. The cost per worker doubles.
3. Asha saves 1,200 a year from age 25 to 65 (40 years) at 5%. Ravi saves 1,200 a year from age 45 to 65 (20 years) at 5%. Compare.
Asha pays in 48,000 and gets about 152,000. Ravi pays in 24,000 and gets about 41,700. Asha paid twice as much but ends with over 3.5 times more, because of 20 extra years of compounding.
4. A pension fund earns 6% a year, but prices rise 4% a year. What is the real return?
Real return ≈ 6% − 4% = 2% a year. The pot grows in buying power only by about 2%.
5. Is EPF in India an example of PAYG or a funded scheme? Which pillar?
Funded: the employee and employer contributions go into the worker's own account and earn interest. It is pillar 2, a workplace pension.
Common mistakes
- Thinking PAYG money is saved for you. It is not; it pays today's retirees at once.
- Thinking a small saving started late will catch up. Time matters more than size, because of compounding.
- Ignoring inflation. A pension of the same number each year buys less and less.
- Mixing up defined benefit (pension fixed) with defined contribution (payment fixed, pension uncertain).