In recent articles I’ve reviewed trends and potential solutions for retirement income from defined contribution (DC) plans. Another option that’s being considered is the use of tontines. The possible implementation of these arrangements is still very much in the discussion stage, but the arguments in their favor are compelling.
Everybody Into the Pool
A tontine is an investment pool with several key differences from mutual funds or other pooled arrangements. Tontine members’ contributions are irrevocable and members’ funds remain in the pool after the member dies. In other words, participants cannot bequest their investment to heirs.
Tontines can be structured in different ways but for retirement-income purposes, the pooled funds might be allocated to income-producing assets. When a member dies, his or her share of the fund is reallocated fairly among the survivors. This creates the so-called mortality credit, which increases survivors’ individual ownership percentage of the pool and their share of its income.
Richard Fullmer, founder of consulting firm Nuova Longevità Research, and Jonathan Barry Forman with the University of Oklahoma College of Law shared an example in an online post:
“Imagine that 1,000 65-year-old retirees each contributed $1,000 to a tontine that purchased a $1 million Treasury bond paying 2% interest coupons. The bond then earns $20,000 interest per year, split equally among the surviving investors in the tontine. A custodian would hold the bond, and because the custodian takes no risk and requires no capital, the custodian would charge a trivial fee. If all investors lived through the first year, each would receive a $20 dividend from the fund ($20 = $20,000 / 1,000). If only 800 original investors were alive a decade later (at age 75), then each would receive a $25 dividend ($25 = $20,000 / 800). If only 100 of the original investors were alive two decades after that (at age 95), then each would receive a $200 dividend ($200 = $20,000 / 100), and so on.”
Pros and Cons
At first glance this tontine design looks a lot like a single-life annuity but there are differences. Fullmer points out that tontines typically can pay out more than annuities because of cost savings. The tontine does not incur risk reserve or hedging costs, allowing more of the pool’s earnings to flow back to members. “I think another (advantage) is that a tontine can be very transparent, whereas typically an annuity is very opaque,” he adds.
Fullmer maintains that tontines also have an advantage over traditional investment portfolios. Both pools rely on their underlying portfolios to generate investment returns. But tontine members’ accounts also benefit from the mortality credits applied when other members die.
Unlike annuities, however, tontines provide no guarantees to pool members. Insurers’ guarantees aren’t free, of course, and annuity owners pay by giving up yield. Tontine payouts vary because the investment returns and annual mortality credits are unknown in advance. A large pool helps to reduce the variability, but each year’s survivor roster is not known with certainty until it’s tallied.
Fullmer and Forman recently wrote a working paper for the Wharton School’s Pension Research Council on the use of pooled annuities and tontines in state-sponsored pensions for private sector workers. They developed projections for a hypothetical 35-year-old male earning $50,000 per year, which grows at 4% annually, who contributed 10% of his salary. Contributions would be split equally between a regular investment account and a tontine-based assurance fund, both earning 7% annual returns on stock investments.
Their simulated projections showed that at age 65 the man would have 7.1% more in his tontine account versus his regular investment fund. Moreover, post-retirement, the investment account was forecast to run out of money at age 84 while the tontine would last until age 120.
Academics have been discussing the potential use of tontines for a while; I first encountered professor Moshe Milevsky’s work several years ago. So far, though, plan sponsors, certainly those in the private sector, are not knocking down the doors to get these products on their DC plan platforms. Forman points to several reasons for the lack of adoption. “There could be some legal hurdles along the way,” he notes. “It's not as easy to fit a tontine pension into the ERISA model that governs private pensions, both defined benefit plans and defined contribution plans.”
Tontines could fit, Forman maintains, but plan sponsors are unlikely to act until their plan or another sponsor has secured the IRS and Department of Labor rulings permitting the arrangement. Another factor is that investment firms are very conservative with innovations, he adds, pointing to the slow adoption rate of 401(k) plans after their approval. Forman says that he and Fullmer agree it will take an existing financial services company’s initiative to promote tontines’ adoption. “We think that the large mutual funds, the large Wall Street firms like Fidelity, Vanguard or Schwab could just jump right in and take away the private annuity market from insurance companies by setting up tontines,” he says. “They already have lots of customers. So it would be possible, but big companies run from the top down and not from ideas down.”
Fullmer, Forman and other researchers have published multiple articles on tontines that provide much more detail than space permits in this column. Here are some suggested resources for further reading:
- Tontines: A Practitioner’s Guide to Mortality-Pooled Investments by Richard Fullmer
- State-Sponsored Pensions for Private Sector Workers: The Case For Pooled Annuities and Tontines by Richard Fullmer and Jonathan Forman