Tontines - A Future Solution to Longevity Risk?
We touch on the problem of longevity risk elsewhere in the website, and how this represents a significant challenge to retirees. How do you know if your superannuation or investments are enough if you don't know whether you will live to 70, 80, 90 or beyond. The response of many people to this is to simply "self-insure"; in other words to save or spend less just in case they are "lucky enough" to live beyond an average lifespan.
Tontines are a very old investment concept that may hold the key to very efficiently addressing the problem of longevity risk. They don't exist in Australia at the moment but various technological improvements, including the use of block chains, may mean that they will be available in the near future.
Rather than being sold as individual products the greatest value from a community perspective would probably attach to tontines being offered by major superannuation funds in Australia, and potentially a requirement that some percentage of funds be allocated to a tontine on retirement. However, quite rightly, there would need to be significant regulatory oversight, and experience suggests that would be anything other than a fast process.
However, we should have commenced with a general description of a "tontine". It is an investment scheme from which shareholders derive a profit or benefit whilst they are living but when they die their share devolves to the remaining participants in the scheme rather than the shareholder's heirs.
So, to be entirely frank, the investors in the scheme receive a regular income which comprises both investment and "mortality" income - with the latter generally increasing as the shareholder ages.
So, why are tontines better than, or an alternative to, annuities in terms of providing longevity protection? Fundamentally because they may be more efficient products, as the product provider doesn't take a "risk" which needs to be reflected in terms of retained capital and nor does it need to be reflected in the product providers margin - with the product provider only basically fulfilling the duties of an administrator. Furthermore, they may allow more bias towards growth investments and therefore a return on capital. Note that we take the view that tontines would not typically replace base annuity income, but would normally be purchased in addition to provide longevity protection.
Efficiency and Cost
Hard data is difficult to find, but it is reasonable to suggest that 30% of the upfront capital paid into an annuity goes to provider profit margins, administration costs and contingency margins - annuities are reasonably complicated products requiring administration over long periods of time. It is the financial world's equivalent of driving a new car out of a showroom and seeing the value plummet immediately. There are obviously administrative costs associated with operating at tontine, but on most analysis they are significantly lower than those attaching to an annuity.
Matching Longevity Risk
Contingency margins are required by life insurance regulators in order to allow for situations where the whole population of annuity holders live longer than expected and to provide a buffer which protects the financial solvency of the life insurance company. There is no requirement for a contingency margin for tontine funds, as the pool is always 100% funded, but of course annuities provide a guarantee which is not present in a tontine.
The premiums received from annuity sales in Australia are generally invested in fixed income assets and government bonds. These are amongst the lowest yielding asset classes and are part of the reason why annuities struggle to attract participants in a low interest rate environment, such as at present. The use of the tontine may allow for longer term investing of the investment pool, perhaps with more of a bias to growth orientated assets, and consequently higher earnings over time.
As a bit of history, it's interesting to note that in 1905 in the United States there were 9 million tontine policies in force amongst the population of 18 million households. The concept is over 350 years old and only came into disrepute because of corruption within the private companies running the schemes and because of the "moral hazard" - highlighted in a number of novels, including one by Agatha Christie, involving situations where some members of the tontine were killed in order to benefit the surviving members.
Much has changed in the meantime and there is the prospect that individual tontines, offered with anonymity and security by use of the block chain, or potentially by major super funds or insurers, will offer some relief from longevity risk, and allow retirees to feel more secure about potentially living "longer than average" and actually enjoying the prospect.
We think tontines are innately less complicated than the myriad types of annuities and offer the prospect of longevity insurance at a reasonable cost - but much, as always, is going to depend on the detail - particularly since you are locking capital away - so professional advice will be absolutely essential before making any commitments to a product such as a tontine.
For those interested in the mechanics and the history of tontines, there is an interesting recent book by Moshe Milevsky entitled, “King William’s Tontine: Why The Retirement Annuity Of The Future Should Resemble Its Past”.