Why Tontines Should Be a Piece of the Retirement Solution

Retirees are often faced with the fear of outliving their assets. This fear, also known as longevity risk, has been eased by the availability of annuities, specifically annuities that I've termed in my paper as guaranteed income products, or GIPs, that offer fixed payments until death.

One would think that a product offering fixed payments for life would be more popular among retirees, but the reality is that Americans choose not to purchase annuities. Why? A big factor is the costs insurers charge as they incur the risk of guaranteeing payments for life. Another is that annuities consist of complex products that require complex regulation, driving the purchase price--and public distaste--of these annuities even higher.

Enter Tontines--A Cheap, Efficient GIP

Broken down, a tontine functions as a pooled investment arrangement where a group of retirees contribute a lump-sum payment into a pool and then receive equal payouts of the total pooled amount for life. Here’s the kicker--as each member of the pool dies, the payout is divided amongst the surviving members of the pool. So theoretically, if only half of retirees in the original pool are still alive, then they’ll be getting twice as much money.

This basic tontine structure works to reduce costs in several ways. First, since insurers no longer incur the risk of offering fixed payments for life (as that risk is now shared within the pool), the cost of administering and managing a tontine is significantly less than the cost associated with the typical annuity product. Second, the cost of overseeing a single pooled investment that requires minimal supervision would be much lower than the costs associated with managing tailored and individualized investment accounts.

Why Aren’t Tontines More Popular?

Tontines offer inexpensive and meaningful protection against longevity risk by allowing retirees to turn their wealth into a stream of income for life. Yet, they barely exist in America today, and most Americans have not even heard of tontines save for plotlines--like The Simpsons and Archer--that involve participants murdering other members of their tontine to collect more money.

Tontines were once so popular that by 1905, an estimated 7.5% of national wealth was held in tontine policies. Instead of offering a regular payout, tontines then were usually dissolved and paid out to the survivors after a specified number of years--usually 20 years. This, as one can imagine, left large amounts of unregulated assets in the hands of the insurance companies who issued the tontines, leading to corruption and impropriety. Tontines became notorious and quickly disappeared from the retirement platter as each state banned financial schemes that did not offer annual payouts.

A Tontine Renaissance

Today, tontines are making a comeback and can take on different forms than the ones that have inspired corruption and murder-mysteries. Instead of leaving a sole survivor to reap the benefits of the tontine pool, members participating in a tontine can agree to dissolve and distribute the assets when the pool reaches a certain number of surviving members. Plus, instead of leaving a large payout for when a retiree is very old, a tontine can be modified to provide guaranteed steady income that would remain constant per survivor.

The United Kingdom has recently released a proposal for employers to launch collective defined-contribution schemes where contribution rates are determined in advance, and participants receive payouts based on the pooled investment and longevity risk.

In Canada, the Variable Pension Life Annuities will soon be offered as an option within existing plans. Retired members would pool their investment risk in groups of at least 10 people and receive payments where participants can expect to gain up to 3% while alive as compared with "equivalent investment products without mortality pooling."

In the United States, the Teacher’s Insurance and Annuity Associate College Retirement Equities Fund, or TIAA-CREF, has allowed investors to participate in a pooled life annuity fund where mortality risk is shared and guaranteed by the pool. Sound familiar?

While not exactly a new product (it has been offered since 1952), the TIAA-CREF's variable life annuity operates essentially, and legally, as a tontine. In exchange for no longer incurring the costs of management fees and insuring mortality risk, TIAA-CREF offers academic retirees a reduced annuity expense charge of 0.45% to 0.70% compared the 1.30% average reported by Morningstar.

Tontine-structured products can be a great supplemental retirement vehicle for a large population of Americans. Tontines can bridge the gap between a retiree worrying about outliving their savings and an insurer or an employer having to insure against longevity. Tontines can ultimately save costs since longevity risk is insured within the pool and not by the insurer, who, as an added benefit, can also reduce management costs. As discussed here and in my paper, Congress should follow the recent global shift and facilitate tontine-structured products for Americans.