Tontine pensions.

• Author: Forman, Jonathan Barry
• Position: Introduction through II. Tontine Pensions B. A Tontine Fund 3. Two Problems with Tontine Funds a. Reducing the Noisiness of a Tontine Fund, p. 755-789

INTRODUCTION I. PENSIONS, ANNUITIES, AND OTHER LIFETIME INCOME MECHANISMS TODAY A. Social Security B. Pensions 1. Retirement Savings Are Tax-Favored 2. Types of Pension Plans 3. The Regulation of Employment-Based Plans C. Other Sources of Lifetime Income 1. Systematic Withdrawals 2. Lifetime Annuities 3. Longevity Insurance 4. Other Lifetime Income Products II. TONTINE PENSIONS A. The Tontine Principle B. A Tontine Fund 1. A Fair Transfer-plan 2. Expected Benefits of Tontine Funds 3. Two Problems with Tontine Funds C. A Tontine Annuity 1. Monthly Accrual of Fair Transfer-plan Payouts 2. Annuity Payback 3. Adding in Investment Income 4. Managing Investments 5. Adverse Selection Is Always a Challenge for Annuities D. Tontine Pensions 1. A Simple Tontine Pension 2. Tontine Pensions Compared with Other Pension Alternatives 3. Summary of the Advantages and Disadvantages of Tontine Pensions III. MODELING A SIMPLE TONTINE PENSION A. The Parameters of the Simulation B. Calculation of the Retirement Balance C. Calculation of the Monthly Tontine-Pension Distributions D. Adequacy E. Tontine Pensions in the Real World IV. REPLACING THE CALIFORNIA STATE TEACHERS' RETIREMENT SYSTEM WITH A TONTINE PENSION A. Background on the California State Teachers' Retirement System B. Replacing the California State Teachers' Retirement System Defined Benefit Plan with a Tontine Pension V. SOLVING THE TECHNICAL PROBLEMS OF CREATING A TONTINE PENSION A. Taxation of Benefits B. Legal Issues C. Dealing with Market Volatility D. Gender Issues 1. In General 2. Employee Contributions 3. Qualified Joint and Survivor Annuities & Qualified Domestic Relations Orders CONCLUSION APPENDIX INTRODUCTION

Tontines are investment vehicles that can be used to provide retirement income. A tontine is a financial product that combines the features of an annuity and a lottery. (1) In a simple tontine, a group of investors pool their money together to buy a portfolio of investments and, as investors die, their shares are forfeited, with the entire fund going to the last surviving investor. Over the years, this "last survivor takes all" approach has made for some great fiction. (2) For example, in an episode of the popular television series M*A*S*H, Colonel Sherman T. Potter, as the last survivor of his World War I unit, got to open the bottle of French cognac that he and his buddies bought (and share it with his Korean War compatriots). (3) On the other hand, sometimes the fictional plots involved nefarious characters trying to kill off the rest of the investors to "inherit" the fund. (4)

Of course, tontines can be designed to avoid such mischief. For example, instead of distributing all of the contributions to the last survivor, a tontine could make periodic distributions. Historically, for example, governments issued tontines instead of regular bonds. (5) In those tontines, the government would keep the tontine investors' contributions but make high annual dividend payments to the tontine, dividing those payments among the surviving investors. (6) When the last survivor died, the government had no further debt obligation. For example, in 1693, the English government issued a tontine to raise one million British pounds to help pay for its war against France. (7) At a time when the regular bond interest rate was capped at 6%, King William's 1693 tontine, as it is known, entitled the surviving investors to share in 10% dividend payments to the tontine for the first 7 years and to 7% dividend payments thereafter. (8)

Over the years, tontines like King William's became quite popular. (9) At one point, Alexander Hamilton, the United States's first Secretary of the Treasury, suggested that the United States could use a tontine to pay off its Revolutionary War debt. (10) All in all, government tontines played an important role in government finances over a couple of centuries, but they have since disappeared. (11)

After the Civil War, tontines emerged as a popular investment for individuals in the United States, but they fell out of favor at the beginning of the twentieth century. (12) The problem was not with the tontine form but with embezzlement and fraud by the holders of tontine funds. (13) Investigations of the insurance industry in New York led to the enactment of legislation in 1906 that all but banned tontines, and tontines have since been replaced by life insurance and similar financial products. (14)

We believe that the time has come to revive tontines as a way of providing reliable, pension-like income for retirees. Specifically, we believe that variations on the tontine principle--that the share of each member of the tontine, at her death, is enjoyed by the survivors--can be used to develop a variety of attractive retirement-income financial products. For example, tontines could be used to create "tontine annuities" that could be sold to individual investors. (15) These tontine annuities would make periodic distributions to surviving investors, but unlike traditional tontines, tontine annuities would solicit new investors to replace those that have died. (16) Structured in this way, a tontine annuity could operate in perpetuity. (17)

In this Article, we consider how the tontine principle could be used to create "tontine pensions" through which large employers could provide retirement income for their employees. These tontine pensions would have several major advantages over most of today's pensions, annuities, and other retirement income products.

At the outset, Part I of this Article explains how the current U.S. retirement system works and how retirees can use pensions, annuities, and other financial products to generate retirement income.

Next, Part II offers a step-by-step explanation of how tontine funds, tontine annuities, and tontine pensions could work today. It then compares tontine pensions with traditional defined benefit pension plans, defined contribution plans, and so-called "hybrid pensions" (e.g., cash balance plans). In particular, Part II shows that tontine pensions would have two major advantages over traditional pensions. First, unlike traditional pensions--which are frequently underfunded--tontine pensions would always be fully funded. Second, unlike a traditional pension--in which the pension plan sponsor must bear all the investment and actuarial risks--with a tontine pension, the plan sponsor bears neither of those risks. These two features should make tontine pensions a particularly attractive alternative for employers who wish to provide retirement income security for their employees but want to avoid the risks associated with a traditional pension.

Part III then develops a model tontine pension for a typical large employer. We then use that model to estimate the benefits that would be paid to retirees. For simplicity, the model assumes that, each year, an employer would contribute 10% of each employee's salary to a tontine pension (in the real world, employers could choose to contribute a greater or lesser percentage of salary on behalf of their employees). The model generates tontine pension benefits for each retiree that would closely resemble an actuarially fair variable annuity--i.e., one without high insurance company fees ("loads"). (18) Specifically, unlike commercial annuities which must support insurance agent commissions, insurance company reserves, risk-taking, and profits, the management and recordkeeping fees associated with running a tontine pension would be minimal. That means that tontine pensions would provide significantly higher retirement benefits than commercial annuities.

Part IV shows how such a model tontine pension could be used to replace a typical, large, traditional pension plan like the California State Teachers' Retirement System (CalSTRS). Like so many other state-run pension plans, CalSTRS is underfunded; for example, as of June 30, 2013, CalSTRS was just 66.9% funded, with an unfunded liability of almost $74 billion. (19) While replacing CalSTRS with a tontine pension would do nothing to reduce that $74 billion obligation, it would ensure that California would never again have to worry about underfunding attributable to future benefit accruals.

Finally, Part V discusses how to solve some of the technical problems that would arise in implementing a tontine pension.

1. PENSIONS, ANNUITIES, AND OTHER LIFETIME INCOME MECHANISMS TODAY

   Longevity risk--the risk of outliving one's retirement savings--is probably the greatest risk facing current and future retirees. (20) At present, for example, a 65-year-old man has a 50% chance of living to age 88 and a 25% chance of living to age 96, and a 65-year-old woman has a 50% chance of living to age 90 and a 25% chance of living to age 97. (21) The joint life expectancy of a 65-year-old couple is even more remarkable: there is a 50% chance that at least one 65-year-old spouse will live to age 94 and a 25% chance that at least one will live to too. (22) In short, most individuals and couples will need to plan for the possibility of retirements that can last for 30 years or more.

   Elderly Americans can generally count on Social Security benefits to cover at least a portion of their retirement income needs. In addition, retirees use pensions, annuities, and a variety of other mechanisms to ensure that they have adequate incomes throughout their retirement years. These financial mechanisms are discussed in turn.

   1. Social Security

      Social Security provides monthly cash benefits to most retirees and their families. (23) A worker builds Social Security protection by working in employment that is covered by Social Security and paying the applicable payroll taxes. (24) Workers over age 62 generally are entitled to Social Security retirement benefits if they have worked in covered employment for at least 10 years. (25) Benefits are based on a...