How do pension providers project your annual pension, since they don’t know when you are going to die?
In: Economics
There is a field called actuarial science that specializes is analyzing data to project average life expectancies and expected future payouts, etc. Pension providers rely on this information to figure out how much they need to put away today so that they’ll have enough money to make the payments in the future. In many cases pension providers don’t have to “pre-fund” their pension payments. They just pay cash out of pocket in real-time.
Insurance companies also use actuaries to analyze medical costs, frequency of claims, life expectancies, etc. This is how they know how much to charge for an insurance policy.
They don’t need to know when you’re going to die. They do need to know how many, out of 10,000 or 100,000 people just like you, will die this year, and next, and the year after that, etc. Given enough people similar to you, they can project with pretty much near certainty how many will die over a given time period, and they make their pension projections accordingly.
This is done by actuaries – very smart people who run massive death data sets through sophisticated analyse to build highly predictive models. These models are very good at predicting death rates (after all, there’s lots and lots of data about who died, when they died, how they died and how old they were when they died).
Pensions are essentially long term bets by pension companies. They promise to pay you a pension from retirement until you die. This means if you live until 110 they will make a massive loss. However, if you drop dead of a heart attack aged 70 they will gain.
This sounds like high risk stuff until you realise they have thousands of pension holders so as long as they project future life expectancy accurately then they are almost certain to have an average spread of life expectancies and so be able to cancel out any losses.
So essentially something that would be a high risk for an individual person – ensuring they spent their savings in a way that both made sure they had enough to last them until death, without having to live on very little in case you live to 110 – is eliminated because the risk is mutualised. It does mean the pensions of the unhealthy and unlucky subsidise those who live longer though.
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