The Case Against Pay-as-You-Go Retirement Systems

Why Retirement Savings Should Stay in the Market

The recent debate around August’s executive order “Democratizing Access to Alternative Assets for 401(K) investors,” which opens retirement savings to “alternative assets,” has raised the question of how far the U.S. government should protect such savings from market risk. Some suggest that retirement savings should not even exist as such; instead, they should be replaced with a large, “risk-free,” state-managed pay-as-you-go (PAYG) system—essentially expanding Social Security’s Old-Age and Survivors Insurance (OASI) into the dominant source of retirement income.

A quick comparison with France, the undisputed champion of PAYG, shows why proposals to replace U.S. retirement savings with a “risk-free,” state-run system are misguided. Far from being riskless, PAYG presents two structural flaws:

1. It exposes savers to risks they can’t hedge against, such as demographics, fiscal balances and employment cycles.

2. It does not grow capital or support the economy, since contributions are merely transferred from workers to retirees without generating investment.

These shortcomings, as visible in the French case as for the OASI fund, should remind American policymakers that capitalized savings as a principal source of retirement revenue is the best solution to support the economy and individual freedom. The flaws of PAYG should also serve as a wake-up call for European countries still wondering why their economy underperforms that of the United States.

PAYG’s Inherent Risks

PAYG systems collect contributions from active workers and redistribute them almost immediately to retirees. For that purpose, France annually raises nearly the equivalent of 15% of its GDP through payroll taxation, which accounts for 98% of retirees’ income. OASI, on the other hand, collects “only” 4% of U.S. GDP. The table below shows the respective GDPs of France, the U.S. and the EU.

PAYG works fine as long as many active workers pay sufficient amounts of tax to fully fund the fewer retirees’ pension entitlements. This very simple three-variable equation has a fragile balance relying on smooth employment cycles, responsible fiscal policy and a positive demography. Let us be generous and presume that unemployment rates are easy to keep low, and that responsible fiscal policy is exactly what governments have always done and always will do. The demography part of the equation is the biggest parameter of a PAYG system and appears, throughout the globe, to be almost impossible to control and predict. The only thing we can say for sure in 2025 is that the population in developed economies is aging, and PAYG systems are starting to feel it.

In France, the retirement contributions inflow, however massive (15% of GDP), cannot keep up with promised benefits anymore, and there are no sufficient reserves to fill the gap. (Contributions are managed by several different public entities. Some of them do build up reserves and even perform well on the market, but the overall scheme does not fund itself.) Notably, the French PAYG system lost around $5 billion in 2024, which represents more than 3% of its meager reserves of about $153 billion, as shown in the table below.

The OASI fund is in the same situation. With proportionally bigger reserves ($2.5 trillion), it has registered a $103 billion deficit in 2024, representing 4% of its reserves. These figures are 2024 snapshots, but past years showed similar results, and it appears as though things will only get worse. Even though the deficit numbers don’t look that alarming yet, they announce that public debt is already coming to the rescue.

For the case of France, with virtually no PAYG reserves, it’s time to borrow. For OASI, despite its large reserves, it’s the same situation. The $2.5 trillion reserves are fully invested in special-issue bonds only tradable with the Treasury. This allows the government to borrow without exposing itself to the market—at first. The system works as long as OASI spends no more than what it collects. As soon as it needs to tap into its reserves, it’s going to cash out a part of the bonds. The U.S. Treasury is going to buy these bonds back by borrowing on the market (or raising tax rates).

It’s interesting to note that these $2.5 trillion reserves represent a considerable 7% of the $37.4 trillion American debt. Sure, the likelihood that OASI will need to empty out its reserves in a very short period of time, thus forcing the government to flood the market with bonds, is very low. But it is certain that PAYG deficit is a synonym for aggravated public debt, whether the scheme has reserves or not.

PAYG systems do bear risks: If productivity drops, for whatever reason, the government has to compensate by taxing, narrowing pensions or borrowing. Acting on these levers translates into less purchasing power for active workers, retirees or both—in the case of borrowing, due to inflation and the dozens of other drawbacks that come with state indebtedness.

It turns out that the legal promise of revenue does not guarantee it. Even if the bigger part of the losses is going to be paid by people who haven’t yet been promised a pension, concrete capital erosion also affects present retirees with pensions that aren’t as valuable or that literally shrank, and it affects present workers who will never receive the benefits of a public service they are paying/being taxed for.

While capitalization systems are not free from risk either, they can at least allow savers to diversify and hedge. Market fluctuations, interest-rate volatility and corporate defaults all affect portfolios, yet savers can spread their exposure to these risks across the world. By contrast, PAYG schemes lock contributors into the economic trajectory of their governments’ employment levels, fiscal discipline and demographic balances, imposing a sort of sovereign risk on individuals. (It must be acknowledged, however, that American retirement portfolios remain heavily concentrated in domestic securities, also exposing them to this sovereign risk.)

Benefits of Capitalized Retirement Systems

Besides the inescapable risks they bear, PAYG systems pass capital from one hand to another and let its value die out in the hands of future generations. On the contrary, a glance at retirement capital in the United States, as shown in the two tables below, illustrates why capitalization matters. With nearly $50 trillion in assets (representing over 170% of the country’s GDP) and around 44% invested in equities and corporate bonds, alongside only 14% in Treasuries, Americans’ savings constitute a massive, diversified engine of growth that cheapens capital and sustains innovation.

*(It should be noted that these tables are aggregations of federal reserve data. Although shares of asset allocation do not add up to a coherent total due to the overlapping classifications used by the federal reserve, the data degree of imprecision still allows for a global idea of retirement capital asset allocation)

France, by contrast, with the hastening collapse of its PAYG system, mobilizes only about $0.48 trillion in capitalized subsidiary retirement funds, barely 15% of GDP. Surprisingly though, asset allocation is not as risk averse as expected, with a mix of around 63% in equities and corporate bonds and 20% in public bonds (shown in the two tables below).

It seems safe to claim that the United States’ capitalized way of dealing with retirement plays its fair share in supporting the world’s No. 1 economy. France and Europe are still stuck wondering why they are not keeping up, but they will get the hang of it someday. In the meantime, the United States, which has always thrived on economic freedom, shouldn’t start dreaming about rusty PAYG systems. Keep your 401(k)s and open them up to all opportunities.