Motivation and Agenda

An insurance company or pension fund promises to pay you $1 for the rest of your life, no matter how long you live. Or they promise to pay you and your spouse $1 for as long as at least one of you is still alive.

How can they promise something like that? How much is this promise worth today? How much was this worth yesterday, and how much will it be worth tomorrow? These are the topics of this chapter, which brings together all the ideas that were introduced and motivated in previous chapters. We are finally ready to discuss pensions.

Market Prices of Pension Annuities

Table 6.1 displays the actual prices (quotes) of pension or life annuities for individuals at various ages. These quotes are based on a $100,000 premium or deposit that is paid at the time of purchase with funds from a tax-sheltered savings plan. I have displayed the payouts based on the average of the “best” U.S. companies quoting in early January 2005.

The $100,000 premium entitles annuitants to receive monthly income for the rest of their lives. In some cases, they are entitled to the guarantee that if they die “early” then their spouse or family receives some payments. For example, a 65-year-old male will receive $655 per month for the rest of his life if he selects a pension annuity with no guarantee (or “certain”) period; should the annuitant die one year (or even one month) after buying the annuity, his heirs receive nothing.