If you pay into a pension for so many years, but end up living a long time then you will have likely gone through the principal as well as any interest earned. How do retirement systems fund this if you’ve drawn more than you’ve saved over the years?
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Actuarial tables.
Pensions earn a significant growth amount over the life of the participant, compounding interest as it goes. Your savings and others grow together with an estimated generalized death date. Some members live longer, some don’t and actuarial tables allow you to plan for the “odds” of the group’s longevity.
The estimated payout amounts are based on that generalized longevity along with the balance of the account itself. Pensions are worked to avoid underfunding (a pension shortfall) however a pension hit by a shortfall will fail to pay out.
You have the main point of the fundamental problem. They make money in three ways
1) You die before you draw more than you put in
2) You have a pyramid set up where more people join than are in retirement so more funds are being put in than drawn.
For these reasons pensions are very difficult, if not impossible to sustain. This is why the US at least largely shifted to the 401(k) / 403(b) type system so long ago that very few people young enough to be on Reddit have ever had the opportunity to participate in a pension.
Ideally, the fund managers invest wisely and the gains keep the fund solvent.
However, they sometimes fail and the pension fund does stop paying out to participants.
There are three sources of continuing pension funds.
1. Some people die before they take out what they put in.
2. There are more people working and putting into the pension fund than pensioners taking out from it, due to population growth.
3. That huge surplus of cash allows for investments, which allows for more growth.
The magic of compound interest.
For every $1000 the company puts away for you in your 20s, they end up with about $30,000 if they just set it in an index fund.
This is metered by the payout formula. If you worked 1 year at the company, they might pay you 1% of your salary, but if you worked 45 years, they might pay you 45%.
So, if you worked 45 years, they’ve made 20-30x whatever they set aside in the first 10 years on investments, and so for 2 years of your pay-in your entire out-take is covered. So, they can decrease your salary by 3% and set it aside.
It should be noted that it decreases *dramatically* and you can do this yourself with a 401k/403b/roth ira. Assuming 8% post-inflation and retirement at 65:
|Age|Money In|Money Earned by Fund|
|:-|:-|:-|
|20|$1000|$31,900|
|25|$1000|$21,700|
|30|$1000|$14,700|
|35|$1000|$10,000|
|40|$1000|$6,800|
|45|$1000|$4,600|
|50|$1000|$3,172|
|55|$1000|$2,100|
|60|$1000|$1,400|
|65|$1000|$1,000|
||||
Say you make $100,000/year and put $3,000 per year into the fund and work at the company the full 45 years.
The fund with 8% growth has $13,914,202. That’s 139 years of your salary, though you were probably making more by the time you retired, a common payout is ~40%, but even if you doubled to $200k and they paid the whole thing, it’d still be 70 years.
It’s remarkably cheap to fund retirement if you start young. You either need a lot of time or a lot of money. Companies also usually have endowments and just company profit that goes to pensions, but big picture if it wasn’t going to pensions, it’d go to salaries, so it’s a salary reduction one way or another.
A few factors… Funds are invested in higher return investments than just savings account interest. Pension fund managers will invest in a mix of stock, bonds, even financing construction projects (provide jobs for union members and investment returns = win/win). Secondly, while some live a long time, others die before they collect any or much pension. They use calculations of average lifespan to determine projected funding needs. There are new members paying in to the pension while older ones draw off it.
I would add that the actuarial tables tend to be quite accurate due to being based on LOTS of data collected over long periods.
It’s a bit like the Las Vegas casinos: The casino is NOT gambling when they appear to be playing with you. You might be “gambling” that you can beat the odds but the math is on their side. Same with both insurance companies and pension administrators based on the actuarial tables.
Where defined pensions “went wrong” gets a bit complex. One part is that the increase in costs for medical services was not well estimated so that left a pretty large hole in many pension plans. They basically didn’t predict that new medical tech would actually increase costs significantly vs reducing costs–more types of procedures and much more expensive to make medications (like biologics).
Another “failure” was actually a feature not a bug in the USA. Reagan changed the law so that the company could put the pension plan on the company books as an asset like they owned it..rather than a liability that they owed to their employees. That created a lot of gaming of the system (such as the corporation borrowing against pension value) which often ended with far underfunded pension plans. This also allowed corporations to invest their pension plans in that corporate stock vs being more properly and broadly invested–meaning if the corporation failed or was badly managed, the pension saw the same.
About the same time in the USA they also made it a **lot** easier for a company to abandon their pension plan and dump it on the federal government (the public) to clean up the mess and pay for. With a little creative accounting, even a profitable company could dump the plan they owed retired employees so the public had to foot the bill. Because the public could not afford the whole thing (plans were usually looted by the company at that point), the retirees got screwed and only got pennies on the promised dollar…if that.
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