Last Friday the Minister for Finance, Charlie McCreevy, announced a Government initiative designed, he said, to provide resources on a planned basis to secure the pensions in retirement of a progressively ageing population.

This initiative, described as a crucial new strategy, is not just necessary, not just imaginative but, in its way, it is brave. It represents a fundamental departure from time-honoured ways of providing State pensions and, critically, from traditional methods of government accounting, which are often limited to a very short-term view.

The traditional approach of governments, in Ireland and elsewhere, to their pension commitments has been a pay-as-you-go (PAYG) arrangement. In the case of Social Welfare pensions, this involves a transfer payment system, facilitated by the State, whereby money provided by the working population and their employers is paid to the dependent sector; in this case, those already retired. Thus the obligation falls on each generation of workers to provide for the generation that went before.

A similar arrangement applies to the government's own employees, except that the money needed to finance pensions in any year is simply a part of current government expenditure, financed from general taxation. Even where employees contribute towards their occupational pensions, there is no attempt to fund the future obligation, no investment of the contributions, which are simply added to general revenue.

Such a system operates throughout the Civil Service, local government and the health service, as well as in the non-commercial semi-State sector. Ordinary employers must fund in advance the pensions they promise. A PAYG system is possible only where government is involved, on the theory that the State will not go bankrupt or renege on its obligations. Even so, if such a system is to work well, its income and expenditure should be in balance, if not year on year, at least on average.

If the number of people making demands on the system increases significantly, or if there is a sizeable reduction in the numbers contributing to its income, the contributions needed to support the system must increase. Up to now, the books have balanced, more or less.

In the case of the Social Welfare system, this was done in the past by a subsidy from general taxation, now at a relatively low level because the income from contributions has increased greatly in recent years. In the case of public service pensions, the numbers of retired people were at manageable levels, compared to the total numbers employed. But all that is about to change.

In the case of the public service, the "baby boomers" recruited in large numbers in the late 1960s and early 1970s are coming close to retirement. Some are already retired. On the Social Welfare side, falling birth rates in recent times will mean fewer people of working age in the second and third decades of the next century. Those people will have to support an increasingly large number of their elders.

Moreover, we are tending to live longer, our pensions must be paid for longer and we will make more demands on the health services in the process. What this implied was a massive increase in the amounts required to fund the system in future.

All of this was recognised. The previous government had taken two important steps. It established the Commission on Public Service Pensions to look into the financing of those; and it launched the National Pensions Policy Initiative (NPPI) to examine the existing pension systems, both occupational and Social Welfare.

Meanwhile, the Department of Social Welfare, as it then was, had commissioned an actuarial review of Social Welfare pensions. It became clear that huge increases in contributions would be needed to maintain the PAYG system, as the proportion of elderly people increased relative to the size of the workforce, from one in five now to one in two over the next 40 years.

A working group in the Department of Finance estimated that the extra cost of pensions by the middle of the next century could be as much as 7 per cent of Gross National Product (GNP). Even if we started in 1999 to try to spread this extra cost evenly, an additional 3.5 per cent of GNP would have to be allocated each year.

There were other problems, too. Almost 30,000 former civil servants had been transferred to An Post and Telecom Eireann in 1984, taking their pension entitlements with them. The two companies set up funded pension schemes to cater for future service, but the government was liable for all the past service of those employees.

There was no money to meet the capital value of this liability immediately. The two funds paid the pensions of retiring employees and, by 1993, the State's accumulated debt was £460 million for pensions already paid, without touching the underlying liability.

Mr McCreevy has announced that the Government will allocate 1 per cent of GNP each year to try to prefund some part of the overall liability for State pensions. Part of the proceeds of the Telecom sale will be used to kick-start the process; another part will buy out the State's liability to the two companies' pension funds. This money will be invested and ring-fenced so that it cannot be used for other purposes.

This decision is in line with the Pensions Board's recommendations in its report on the NPPI, Securing Retirement Income. It is rendered possible by the present buoyancy of the economy. Its precise effects on future costs are hard to estimate: there are too many unknowns, not least the returns that the investment will produce. The Minister points out that this initiative might cover only one-third of the increase in costs.

Nevertheless, to commit the Government to this funding on a systematic basis is a courageous decision, and one for which future generations of Irish workers and their employers will have reason to be grateful. It will be viewed somewhat enviously by our partners in Europe, who are grappling with similar problems.

Paul Kenny is head of retirement research at Mercer Ltd/Irish Pensions Trust