Bring Back The Tontine for Retirees?
In today’s world, newly-minted retirees are being forced to take on risks that their predecessors did not have to deal with. Prior to the 1990s, a retiree could typically count on a guaranteed amount of income from social security and from company pensions lasting until he or she passed away. In effect, the federal government and the employer took on the worker’s longevity risk and investment risk, enabling him or her to enjoy a relatively anxiety-free retirement (financially-speaking). But there’s a pretty hefty cost to taking on such risk, and by 2015, few private companies still offered pensions (also known as defined benefit plans). Even the many lucrative public employee pensions have been cut back dramatically. The insurance industry has responded by ramping up the feature set and the marketing of annuity products as alternatives for guaranteed lifetime income. (This is not altruistic on their part; annuities represent a tremendous profit opportunity for them). But offering annuities subjects insurance companies to the very same risks that employers faced with pensions, namely how to support future promises without losing money in case projections turn out to be too optimistic. Moshe Milevsky, a professor at York University in Toronto, has proposed the reintroduction of the tontine as a better solution for retirees. What is a tontine, how is it different from an annuity, and how is it better?
First, it’s important to understand how an annuity works. A single premium immediate annuity (SPIA) is the most basic type, in which the annuitant pays the premium up front and immediately starts receiving a stream of fixed payments guaranteed over his or her lifetime. The insurance company offering the annuity pools the premiums from the various annuitants, invests the principal, and distributes a portion of the earned interest (sometimes together with some of the principal) back to the annuitants on a periodic basis.
In order to make a profit, the company has to address the two risks above. They utilize actuaries to estimate the amounts and the timing of the needed payouts and investment advisors to ensure that the principal is well-protected in case of market downturns. That, together with the maintenance of a capital reserve to ensure there’s always enough cash available for payments to annuitants, results in a significant drag on the amount of income the annuity can provide.
A tontine has a similar structure. The organizer (King William in Milevsky’s book on the topic) pools investments from multiple participants, invests the principal, and promises a guaranteed lifetime income stream. The main difference is that the longevity risk and investment risk are borne by the participants, not by the organizer. As a result the tontine does not guarantee fixed payments. If investment returns should decline in a particular year, the participants would receive less income that year. On the other hand, as the participants get older and some begin to die off, a smaller number will remain to collect the interest earned on the pooled assets, resulting in higher payments to the survivors.
Although the fixed payments of an SPIA can be considered a benefit in that there is no income uncertainty, they will not keep up with inflation, particularly over a long retirement horizon. This turns out to be one of an annuity’s biggest drawbacks. A tontine, by contrast, will increase payments as participants get older. In that way the tontine provides a better hedge against inflation. (It’s not perfect, however; if a cure for cancer or some other life-extending medical breakthrough is discovered, and the tontine participants were to consequently live longer, that would likely delay any increases in the tontine payouts). Alternatively a tontine could be structured to provide more level payments over a lifespan, resulting in higher initial income to participants than that provided by an SPIA. Although the inflation hedging benefit would be reduced, the ability to spend more during the earlier retirement years might be worth the tradeoff.
Tontines are also cheaper to administer than are annuities. Without the cost of managing longevity risk, there’s no need to hire actuaries or to maintain cash reserves. There’s still the need for basic administration (for example premium collection, principal investing, and payment distribution), but those costs are small relative to those incurred mitigating risk.
According to Milevsky, poor regulation as well as abuse by insurance companies resulted in legislation eliminating tontines over the last century. But he believes there should be no major legal barriers to resurrecting them as structured above, if not by insurance companies, then by those employers that bailed out of pensions primarily to avoid having to take on the risk. Even nonprofits such as churches ought to be able to create tontines for their members.
The problem with any guaranteed income solution for retirees is that somebody will have to pay when the assumptions used to estimate the guarantees don’t pan out. With a tontine, the retiree bears that risk but mitigates it by sharing it across a broad population. Although certainly not the solution to every unique retirement need, tontines, with their advantages over annuities, do potentially represent an additional solution to the retirement planning puzzle.