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This article first appeared in the Georgetown University Center for Retirement Initiatives blog. The quest for retirement security faces significant challenges in virtually every country across the globe. Traditional defined benefit (DB) pensions are challenged by increasing life expectancies, a lower ratio of workers to retirees, and historically low interest rates—all of which have served to dramatically increased the cost to finance retirement. This cost involves a number of assumptions that each involve a level of uncertainty. Thus, the act of promising a specific level of retirement benefits to workers is an expensive and risky endeavor. Defined contribution (DC) arrangements present a different set of challenges. One is that they place the financial burden on individuals, who often lack the financial literacy and acumen necessary to manage the accumulation and subsequent decumulation of retirement savings. Moreover, many workers do not have access to employer-sponsored retirement savings programs. States have begun to address this “access problem” by sponsoring programs that give workers who would not otherwise have access to an employer-sponsored retirement savings plan the ability to save into individual retirement accounts via automatic payroll deduction. While these state-sponsored programs help individuals accumulate savings in their working years, they do little to help people decumulate their savings when they reach retirement. Retirees are left to determine for themselves how to convert their savings accounts into lifetime retirement income—a task so formidable that Nobel laureate William Sharpe has called it “the nastiest, hardest problem in finance.” It simply is not realistic to think that most people can manage the decumulation problem effectively on their own. Financial advisors can help, but of course for a fee, which means less residual income for the retiree to live on. The current system is inefficient and subjects many Americans to the risk of running out of money in old age. State-sponsored tontine pension assurance funds State and national governments could address these issues by sponsoring a new form of lifetime pension—tontine pensions that could be added as an option to virtually any defined contribution (DC) plan and could help provide retirement income security for millions of private-sector workers who currently lack pension coverage, with minimal risk to the government as sponsor. We propose a way to deliver such pensions through a new vehicle that we call assurance funds. The term ‘assurance’ is used to differentiate these products from ‘insurance’ products, in that they are not based in any way on the principle of indemnity or a contract of risk transfer. Assurance funds are complementary to traditional DC offerings, but better suited to delivering lifetime income in retirement because they would operate according to the survivor principle—that the share of each, at death, is enjoyed by the survivors—meaning that retirees would enjoy higher incomes that last as long as they do. Assurance funds offer some of the same features as traditional DB pensions, such as mortality risk pooling and lifetime payouts. A big difference, however, is that their sponsors would not promise a specific benefit level—and thus would avoid incurring defined benefit liabilities. This is because assurance funds would not operate as DB pensions, but rather as tontine pensions. A tontine pension is a financial arrangement in which investors mutually and irrevocably agree to receive payouts while living and share the proceeds of their accounts upon death. In this way, individual longevity risks are pooled and spread out among all of the tontine pension members rather than borne individually. An investor’s tontine pension account is forfeited at her death, with the proceeds fairly apportioned among the surviving investors as mortality credits. Payout levels are not guaranteed. Instead, they vary over time in accordance with a strict budget constraint that forces them to remain fully funded at all times. This means that the payouts vary depending on the performance of the account owner’s investments and the collective mortality experience of the tontine membership. The budget constraint ensures that tontine pensions always remain grounded in economic reality, which we believe makes them an attractive option for states and retirees alike. Implementing assurance funds As we envision them, assurance funds could be offered as investment options on the new Secure Choice programs being created by states like Oregon, California, Illinois, and Maryland that offer the opportunity to participate in state-sponsored retirement savings plans. Adding an assurance fund could effectively turn these retirement savings plans into lifetime pensions. Participants could allocate their contributions between regular investment funds and assurance funds, and, in partnership with various private-sector investment and record-keeping companies, the state-sponsored pension would manage and invest those designated contributions and make the appropriate payouts to retirees and their beneficiaries. Moreover, assurance funds could be invested in the same underlying regular investment funds that a plan already offers. For example, if a plan offered five different mutual funds as investment choices, it could elect to offer the same five investment choices as assurance funds. Compared with commercial annuities, assurance funds would provide lifetime income, but would not guarantee a precise level of that income. By doing away with the cost of guarantees, assurance funds would provide higher levels of lifetime income, on average. Their payouts would also be significantly higher than could be attained through withdrawals from traditional mutual funds because investors would earn not only investment returns, but also mortality credits that grow exponentially with age. In a world with substantial levels of undersaving, economic efficiency is vital. Defined benefit pensions are slowly disappearing while many of those that remain suffer from chronic underfunding, prompting concerns about sustainability. Assurance fund income would not be fixed and it would not be guaranteed. Rather, it would be variable and nonguaranteed. But it would always be fully funded and, therefore, fully sustainable … forever. Richard K. Fullmer is founder of Nuova Longevità Research and cofounder of Nuovalo Longevity Income Solutions. Jonathan Barry Forman is Kenneth E. McAfee Centennial Chair in Law at the University of Oklahoma College of Law. This article first appeared in the Georgetown University Center for Retirement Initiatives blog.

Tontines, a nearly-extinct financial device invented centuries ago, are receiving fresh attention as a tool for retirement income. We do mean fresh – modern tontines envisioned by economists today have evolved since the tontines of yestercentury. Brief history Tontines were originally used by nations to finance wars against other nations. The government would offer to borrow money from the citizenry with a promise to pay an interest rate for the rest of each tontine shareowner’s life (or the life of another person that a shareowner might nominate, often a young child). Later, private insurance companies began to issue a product called “tontine insurance” with similar characteristics. The products had become quite popular by the end of the 19th century. Sadly, the products fell victim to misappropriation and fraud on the part of their issuers. Regulators in several countries banned certain troubling aspects of the “tontine insurance” products being sold at the time, and they quickly became extinct… well, almost. Tontines persisted on a small scale in France. A few public pension systems, such in Sweden and the U.S. state of Wisconsin, operate with tontine-like characteristics. So, too, does the CREF variable annuity that has been sold within the U.S. since 1952. More recently, the European Union moved to allow tontines. South Africa has followed suit beginning with the informal economy, Australia has been considering tontine-like group self-annuitization schemes, and Canada has likewise been considering tontine arrangements. Financial regulation is now far stronger than it was over a century ago when bad-acting tontine issuers met their downfall. Recordkeeping, custody, and auditing systems have been created and improved to prevent the misappropriation of retirement assets. Even so, the wheels of financial regulation often move slowly. Regulatory hurdles to these products remain in the U.S., U.K., and many other countries. Still, the global trend is gradually moving toward acceptance, and for good reason – tontines represent a useful and highly efficient approach in addressing the global retirement problem. The retiree’s problem Post-retirement portfolio decumulation presents one of the thorniest challenges in finance. The problem is longevity risk – the risk of outliving the portfolio’s assets over a highly uncertain lifespan. The challenge is to economically deliver an income stream that reliably lasts for the rest of a retiree’s life, no matter how long. This is difficult even for professionals at the institutional level as the sad state of so many defaulted and endangered pension plans – and even social security programs – will attest. The challenge is arguably even harder for individual retirees, who have but one life and therefore one chance to get it right in the face of much uncertainty. Unfortunately, few tools exist for managing longevity risk. One approach is to manage it oneself, typically by investing and withdrawing conservatively to guard against adverse markets or a long life. Another approach is to transfer the risk to an insurance company by purchasing a guaranteed life annuity. These approaches, each with benefits and drawbacks, are not mutually exclusive, and many advisors recommend a blended approach in which retirees utilize both to one degree or another. Tontines themselves represent a blended approach – a kind of noninsured annuity that many retirees might find attractive. Lifetime uncertainty and lifetime income Insurers are able to guarantee lifetime income by 1) relying on the power of mortality risk pooling to greatly diversify the risk, 2) setting aside reserves to guard against undesirable outcomes, and 3) charging an additional markup for other expenses and profits. Pooling many lives together diversifies risk because although it is highly uncertain how long any one person will live (called idiosyncratic risk), it is far less uncertain how long a large number of people will live in aggregate. With a large pool, substantially all of the idiosyncratic risk component can be effectively diversified away. Insurers also bear the risk that the entire population lives longer than expected (called systematic risk), which is not diversifiable. Undiversified risk is quantified and priced, with a portion set aside as a risk reserve. An additional markup may also be priced in as a profit margin. The retiree’s perspective For retirees, the idiosyncratic component is by far the most worrisome – Yikes, will I live another 10 years… or another 40 years? The systematic component is typically much less worrisome – Might the life expectancy of my age cohort in aggregate turn out to be longer than the experts think? What if there was a way for retirees to inexpensively diversify away the worrisome idiosyncratic risk and retain the less-worrisome systematic risk, avoiding all insurance costs? Enter tontines. What is a modern tontine? Think of a modern tontine as a collective investment pool that pays out according to some pre-determined formula – as a lifetime annuity, for example. No insurance is involved whatsoever. The twist is that as members die, their share of the pool is forfeited and redistributed fairly to the remaining surviving members. Thus, members receive not only their share of investment gains and losses, but also a share of the final account balances of those who predecease them. In this way, tontines offer a way for retirees to collectively self-pool their longevity risk without involving an insurer. This diversifies away idiosyncratic risk every bit as effectively as an insured annuity. Tontine members still bear systematic risk in that payouts over time could end up being somewhat lower (or higher) than anticipated if the membership lives longer (or shorter) on average than expected. As with insured income annuities, tontine investments would be irrevocable. It is therefore unlikely that anyone would want to put their entire savings into one. But even a partial allocation would help mitigate longevity risk. Ensuring fairness Of course, the redistribution of forfeited account balances should be done fairly such that no member is advantaged or disadvantaged. Ideally, the method of redistribution should be easy to understand and readily perceived by experts and laypersons alike as fair. A useful analogy is the parallel between fair game design and fair tontine design. For example, a game is considered fair when the expected return to each player is zero each time that the game is played. Casino games are not fair since the odds favor the house (which is an active player in every casino game). In fair games, however, no player – not even the house – has any advantage or disadvantage. The concept is similar in a fair tontine. For each member, the expected value of forfeitures gained while living is designed to equal the expected value of forfeitures lost at death. At this point you might be thinking, “Wait… if the expected net value of these forfeiture distributions is zero, why invest in a tontine?” The answer is that the tontine changes the conditional distribution of outcomes in a very useful way. By participating in a tontine, those who die early receive less and those who live longer receive more. This is exactly what retirees who are dependent on their retirement savings need. Payouts Because tontines come without any sort of guarantee, their payouts cannot be fixed but rather will vary depending on investment performance and the mortality experience of the membership pool. Those that desire smoother payouts would invest their tontine assets more conservatively, perhaps even in Treasury bonds with laddered maturities to help reduce payout volatility to a minimum. Tontines could offer a wide variety of payout options. Examples include a life annuity, a deferred life annuity, a term annuity, or a simple lump-sum term investment. Payouts could be based on the life of an individual member or the last-to-die of a couple. Note that because they make no guaranteed promises, tontines can never become underfunded. No promises means no underfunded liabilities – ever. Transparency Unlike annuities, tontine pricing and accounting can be completely transparent. Fees would be clearly disclosed upfront and could be quite low, especially if the tontine assets were invested passively. All cash flows that affect a member’s account could be disclosed on periodic account statements and easily audited. Furthermore, some suggest that tontines could operate on blockchain technology, providing an immutable record of every transaction. Versatility When most people think of a tontine, they think of a particular investment pool packaged with a particular payout formula. However, fairly-designed tontines are much more versatile than this. For example, fair tontine brokerage accounts could be developed in which members are different ages and genders, invest different amounts at different times, select their own investments, trade however they wish, and select from a wide variety of different payout options. It may seem puzzling that an aggressive investor is not disadvantaged by being in a pool full of conservative investors. Wouldn’t he be better off if the other members likewise invested aggressively and died with larger balances? Counterintuitively, the answer is no. That is the beauty of fair tontines – like fair games, they are fair to all regardless of who else participates or how they participate (explained here). Who might be interested in tontines? Tontines might be of interest to: Employers that wish to offer defined-benefit-like employee pension plans that can never become underfunded (tontine pensions) Defined-contribution plan sponsors who wish to include a lifetime income option in their plans, while avoiding the fiduciary liability associated with selecting a guarantor Investors who wish to increase investment return without increasing investment risk (and are willing to irrevocably give up a liquidity tradeoff) Anyone seeking the assurance of lifetime income with greater transparency and at lower cost than with insurance products (albeit without a fixed guarantee) Asset managers who wish to challenge insurance companies in the market for lifetime income Public policymakers who wish to encourage participation in lifetime income solutions Conclusion Modern tontines represent an attractive solution in addressing the retirement income challenge. They offer a low-cost way to derive extra income without taking on additional investment risk. They provide the assurance of lifetime income in a way not possible with traditional investments. As a type of noninsured annuity, they efficiently diversify away idiosyncratic longevity risk, yet dispense with the overhead costs and opaque pricing associated with insured annuities. Tontines do have drawbacks. Investments are irrevocable, account holders cannot withdraw freely however and whenever they wish, and payout levels are not guaranteed. No single product represents the best of all worlds, but consumers can benefit by having an expanded set of choices. Tontines represent a highly useful alternative with unique benefits not otherwise available from traditional investment and annuity products. With a little help from policymakers and regulators to open the market, we expect modern tontines to flourish.

A version of this article also appeared in the Retirement Income Journal. Tontines are a much-misunderstood investment arrangement that deserve a fresh look. Put aside everything you thought you knew about them. Forget the devious plots found in fiction novels, and do not confuse modern day tontines with the sketchy, opaque products called “tontine insurance” that were banned out of existence a century ago. Modern tontines such as we envision are fair to all, completely transparent, simple to understand, perpetually open to new members, always fully funded, able to provide the assurance of lifetime income to those who want it, less expensive than guaranteed lifetime income alternatives… and surprisingly versatile! In a study, we explored this versatility potential by examining the concept of tontine brokerage accounts in which individuals freely invest as they choose and select from a wide array of payout options. We show that such arrangements, which we call individual tontine accounts, or ITAs, can be fair to all members regardless of who else is participating and what decisions they make in their own accounts. ITAs could serve as a special type of longevity risk pooled Individual Retirement Accounts (IRAs), allowing retirees to derive extra income from their savings without taking on additional investment risk, and giving them the option to secure annuity-like lifetime income at lower cost. The time is ripe to take a serious examination of the modern-day fair tontine as an important new arrow in the quiver for addressing the global retirement crisis. Background: What is a tontine and how is it different? A tontine is a financial arrangement in which members mutually and irrevocably agree to receive payouts while living and share the proceeds of their accounts upon death. Specifically, a member’s account is forfeited at death, with the proceeds apportioned among the surviving members. Payouts naturally vary depending on investment performance and the mortality experience of the membership pool. Tontines offer investors a way to pool mortality and longevity risks directly among themselves, without intervention by any insurance company. Risk pooling is powerful because although the lifespan of any individual member is highly uncertain, the lifespan of the group is much less uncertain. Tontines allow members to diversify away substantially all idiosyncratic longevity risk – the uncertainty associated with how long they will live and how much they can withdraw/spend without outliving their savings. Members do bear systematic mortality risk – the risk that the entire membership group lives longer or shorter than expected. However, this is mitigated in that adjustments to tontine payouts are made gradually over time. Should the membership die slower (faster) than expected, payouts adjust downward (upward). These continual adjustments, along with similar adjustments for investment performance, are the mechanism that keeps the tontine fully funded at all times and allow it to offer the assurance of lifetime payouts. To anyone concerned about the sad state of underfunded pensions, these words are music to the ears. How does a tontine compare to a payout annuity? Unlike payout annuities, tontines guarantee nothing. Fixed income annuities guarantee some assumed interest rate, whereas variable income annuities do not. Both types of annuities provide guarantees that cover both the idiosyncratic and systematic components of longevity risk. Tontines alleviate the idiosyncratic component only, but keep in mind that this component represents the greatest worry by far. In addition, since insurers must charge for the risks they take on, annuity purchasers sacrifice a significant yield as the price for transferring the systematic component of mortality risk to an insurer rather than bearing it themselves. How do tontine returns compare to those a regular investment? The total return of a tontine investment is a function of two components: 1) the investment returns, and 2) the amounts credited to survivors when other members forfeit their accounts at death. It is the second component, which may be referred to as “longevity credits” or “tontine gains,” that makes the tontine return different from that of a regular investment. Tontine gains reflect the extra amount credited to a surviving member’s account due specifically to having invested in a tontine. Members suffer complete tontine losses when their account balances are forfeited upon death, but surviving members enjoy tontine gains when the proceeds of these forfeitures are shared among them. For actuarially-fair tontines such as we advocate, the net effect is that the expected total tontine “Zero?” “Yeah, zero is a wonderful thing. In fact, zero is my hero.” As proffered in the 1973 Schoolhouse Rock song lyrics by the late jazzman Bob Dorough, zero is a wonderful thing. That the expected net total tontine gain for each member is zero means that the expected total return of each member’s investment is the same regardless of whether it is made inside or outside of the tontine. This principle is what enforces fairness – no one is advantaged or disadvantaged by entering the tontine. The useful thing about this is that although the expected value is the same whether inside or outside a tontine, investing inside a tontine changes the conditional distribution of outcomes – those who live long lives do better by participating in the tontine, while those who die early do worse. Individual Tontine Accounts We envision ITAs as either defined contribution retirement accounts or individually-owned investment brokerage accounts offered through a common tontine pool. In the latter case, they could be opened as IRAs or standard taxable accounts. Contributions are irrevocable, but members may invest and trade as they wish, selecting among a range of permissible liquid investments, including stocks, bonds, exchange traded funds (ETFs), and mutual funds. Naturally, those desiring smoother payouts would select more conservative (i.e., less volatile) investments. At the time an account is opened, the member elects a payout option from a wide variety of alternatives. Examples include lifetime payouts similar to immediate life annuities, deferred lifetime payouts similar to longevity insurance, payouts over a specified period similar to term annuities, or even a simple term investment. This election is binding such that the selected payout schedule may not be accelerated. Fees would be plainly and transparently disclosed, and all-in costs to members could be very low when low-cost investments are selected. Our proposed method of tontine accounting is fully transparent and readily auditable. Member statements are easy to understand, showing a full accounting of the cash flows that affect a member’s account balance and payout. Surprise!… The decisions of others do not matter One of the most paradoxical attributes of fair tontines in general and ITAs in particular is that an individual member’s results are largely unaffected by the investment and payout choices of the other members. How can it be that an aggressive investor is not disadvantaged by being in a pool full of conservative investors who are likely to die with lower balances than if they had invested more aggressively? Wouldn’t the aggressive member be better off if the other members also invested aggressively and died with larger balances? The surprising answer is no – the decisions of others will not much matter (nor will their demographics). Those who find this puzzling may wish to read our Individual Tontine Accounts paper. Conclusion Individual tontine accounts are an attractive solution in addressing the retirement income problem. They operate like IRA brokerage accounts, with the added benefit of providing tontine gains on top of a member’s underlying investment returns. Economists and public policy makers have long pondered the so-called annuity puzzle; namely, why do so few people annuitize when it seems to be in their interest to do so? To the extent that the answer involves the perceived high costs and lack of transparency of annuity products, ITAs represent an attractive remedy. ITAs give retirees a low-cost way to derive extra income from their savings without taking on additional investment risk. Since account holders cannot withdraw freely from their accounts whenever they wish but rather only per a payout schedule selected at the time of contribution, ITAs are not a complete replacement to traditional IRAs. But they could be a very useful complement, and one with unique benefits not otherwise available from traditional investment and annuity products. A version of this article also appeared in the Retirement Income Journal.

Innovations in longevity risk pooling took center stage at a panel titled What Could a 21st-Century Lifetime Income “Pension” Look Like? at the Georgetown University Center for Retirement Initiatives Annual Policy Innovation Forum, a three-day event that ran October 20—22, 2020. Our own Richard Fullmer presented on the topic of Modern Tontine Pensions. The panel was moderated by Charles Millard, Former Director of the Pension Benefit Guaranty Corporation (PBGC). Other panelists included: Doug Kincaid, Assistant Vice President of Greenwald Research Tamiko Toland, Head of Research of CANNEX David Pitt-Watson, Visiting Fellow at Cambridge Judge Business School (UK) David Pratt, Jay and Ruth Caplan Distinguished Professor of Law at Albany Law School The presentation slide deck can be found here.

The work of Richard Fullmer and our sister company, Nuova Longevità Research, is referenced in this thoughtful policy brief published by the Brookings Institution titled Retirement Tontines: A New Way to Finance Retirement Income. Insightful quotes: “Considered as a financial innovation, it [the tontine] was very successful. Considered as insurance, it was actuarially sound. Considered as a gamble, it was a ‘fair bet’ … Considered as a life-cycle asset, it proved to be an excellent investment.” — Ransom and Sutch (1987). “Tontines are investment pools where members commit funds irrevocably and where the interests of members who die are given to those who survive. Tontines were popular in the U.S. in the late 19th and early 20th centuries, until they were effectively prohibited in response to insurance company mismanagement. Tontine-inspired products are receiving renewed attention around the world as efficient, transparent ways to finance retirement. Unlike fixed income annuities, tontine pooling does not guarantee future payments, but should pay more on average per dollar invested, with less costly regulation.” Additional links: Full research paper Presentation

“...the arguments in their favor are compelling." Our research on tontines for the Wharton Pension Research Council is referenced in this article by Ed McCarthy.

“A tontine is a financial vehicle that allows people to pool their assets and their mortality risk and thereby enhance their savings. We envision tontine savings accounts (TSAs) as taxable or tax-deferred retirement accounts, with investors free to select their investments and payout method. Payouts could be 10% to 15% higher than those of commercial life annuities." Read our article in the Retirement Income Journal here.

Benjamin Franklin once famously wrote “… in this world nothing can be said to be certain, except death and taxes.” ¹ True, death is indeed certain. However, the timing of death is quite uncertain. This uncertainty greatly complicates financial planning by imparting upon we mortals the challenge of managing longevity risk — the risk that you will outlive your savings. Managing longevity risk involves a complex interaction between three underlying components: The rate of withdrawal from your savings, The rate of return on your investment portfolio, and The length of your remaining lifetime, which you can think of as your “rate of mortality” (an unpleasant thought perhaps, but no more so than Franklin’s unpleasant truth). While establishing a spending budget may be largely within our control, investment returns are uncertain, and life spans are even more uncertain. Managing Longevity Risk Notice that each of the underlying components is quantifiable as a rate — rate of withdrawal, rate of return, rate of mortality. This insight holds the key to understanding the ways in which longevity risk can be managed. Each component can be thought of as a lever in which to manage the overall risk of running out of money before you run out of life. Spending Lever — Rate of Withdrawal The spending lever is straightforward and involves withdrawing from your savings conservatively to guard against the risk of encountering a severe and prolonged bear market or the risk of living significantly longer than expected. A consequence of spending conservatively is that it is likely to result in material underspending of savings for most people. Moreover, since uncertainty over your future investment returns and your future life expectancy never goes away, the need to spend cautiously will never go away either. This lever manages the problem, but does not solve the problem. Investment Lever — Rate of Return The investment lever is not nearly so straightforward. Yes, increasing your expected rate of return will lead to a reduction in longevity risk. However, modern portfolio theory teaches us that higher returns come with higher volatility, which unfortunately has a counteracting effect of increasing longevity risk. As a result, selecting an investment strategy as a way of managing longevity risk involves a “damned if you do, damned if you don’t” kind of tradeoff. This dilemma presents a tremendous challenge even for those of us that study this kind of thing for a living. To wit: financial economist and Nobel laureate Bill Sharpe has called the retirement income challenge, “the nastiest, hardest problem in finance.” Lifespan Lever — Rate of Mortality The lifespan lever is perhaps the most useful because, although mortality risk involves the greatest degree of uncertainty, you don’t actually have to bear it. Instead, you can transfer it to others — and eliminate longevity risk in the process! Life insurance companies are in the business of accepting this kind of risk transfer through a vehicle known as a life annuity. By selling life annuities to a large number of people, insurers are able to aggregate a set of highly uncertain individual lifespans together in a manner known as risk pooling. Risk pooling is integral to all kinds of insurance — automobile, windstorm, fire, health, life, death. The key ingredient required for risk pooling to work is a large number of independent risk exposures. By pooling independent risk exposures together, the uncertainty of outcomes in the aggregate becomes much less than that borne by any individual. At some point when the insurance pool is sufficiently large, the uncertainty level will have decreased enough to confidently quote a price for accepting the risk. Fortunately, individual lifespans are largely independent — one person’s death (or in this case “non-death” since the risk is of living too long) does not typically result in a large number of other person’s deaths (non-deaths). So although the insurance provider has no idea when you or I might die, it will have a fairly good idea the percentage of people who will die at various ages in aggregate… and that is what matters. Of course, this transfer of risk from individual to insurer does not come without cost. One cost is the fair price for accepting the aggregate risk exposure. Recall that risk pooling does not eliminate risk in the aggregate. Moreover, there remains the risk that the group of insured annuity buyers lives longer in aggregate than the insurance company had expected. As a result of this risk and others (for example, most annuities also transfer investment risk to the insurer), another cost lies in the setting aside of reserves to help ensure all of the promised future payouts can be sustained. Other costs include administrative, operational, marketing, and sales related expenses. The latter category of expense can be significant given, as the saying goes, that “annuities are sold and not bought.” A More Natural Way — Tontines Annuitization offers tremendous benefits, not the least of which is guaranteed income for life. For retirees, the act of eliminating longevity risk is both stress-relieving and empowering. Furthermore, most economists agree that longevity risk pooling is the rational thing for retirees to do. But if doing so via annuitization sounds a bit artificial, well, it is. What if retirees could transfer away longevity risk more naturally, at less cost, without having to involve an insurance company as middleman? Well, they can. Tontines effectively do this. A tontine is an investment scheme in which surviving members effectively inherit the account balances of those that die. In this way, tontines allow individuals to collectively “self-pool” longevity risk without involving an insurance company as a middleman in the transaction. The tontine itself aggregates the individual longevity risk of its members, and does so every bit as effectively as an insurance company. To quote Michael Finke, dean and chief academic officer at the American College of Financial Services, in his July 2015 Research Magazine article: “As it turns out, everything we need to know about building a perfect retirement product we learned in kindergarten. Life is better when you share.” There are two important differences between an annuity that makes lifetime payouts and a tontine that makes lifetime payouts. First, annuity payouts are guaranteed while tontine payouts are not. Second, annuities are naturally more expensive… precisely because they are guaranteed! How can a tontine offer lifetime payouts without the backing of reserves? The answer is that a tontine is, by definition, “fully funded” at all times. Payouts are not fixed, but rather evolve over time in response to investment returns and aggregate longevity. Thus, future payouts will adjust downward if current returns are lower than the “fully-funded rate” expected by the tontine provider. Likewise, payouts will adjust downward if the pool of tontine members prove to be living longer than expected. Conversely, future payouts will rise if returns are higher than expected or tontine members pass away faster than expected. By continually making adjustments as necessary, members can be assured that the payouts will last as long as they do. In short, tontines act as a longevity risk pooling collective in which members voluntarily aggregate and share individual longevity risks among themselves. This longevity risk pooling, combined with payout adjustments that maintain the pool’s fully funded status, effectively eliminates longevity risk for each member. Investment risk and aggregate longevity risk are retained and likewise shared by the members in the form of payout adjustments.² Tontines and annuities are different solutions to the same problem. Whether or not the guarantee offered by a fixed annuity is worth the extra cost is a matter of personal preference. Although some level of variability will always exist in a tontine’s payout stream, fluctuations can be made modest if the tontine invests conservatively and maintains a sufficiently large number of members. Most retirees can probably accept some level of variability in their retirement income. After all, we spend our entire lives learning to adapt, don’t we? By collectively sharing longevity risk among themselves and dispensing with cost of guarantees, retirees may be able achieve significant cost savings using tontines rather than annuities. Endnotes ¹ “The Private Correspondence of Benjamin Franklin… Published from the Originals, by his Grandson William Temple Franklin”, Volume 1, Second edition, p. 266. ² Neither investment risk nor aggregate mortality risk can be pooled since these exposures are not independent. When the market falls for one investor, it falls for all investors. Similarly, when life expectancy unexpectedly increases in the aggregate, it does so for everyone by definition.

Tontines are a type of investment in which the account balances of shareholders who die are forfeited, divided up, and transferred to shareholders who are still living. Exactly how they are divided up and transferred is a critical element of tontine design. Everyone should care about this whether they are investors, prospective investors, advisors, or regulators. Dividing Forfeitures Fairly and Equitably A fundamental principle of tontines is that their design should be fair to all investors. This means that forfeited balances be transferred to survivors in an equitable manner such that no investor (and therefore no class of investor) is unfairly disadvantaged. But how? And what does this even mean? To help answer this, let’s start with a few intuitive examples. Fair Games A game or bet is fair to all parties if each party’s expected gain is zero. Consider the classic coin flip in which a player wins (say 1 USD) if the coin lands on heads, and loses (say, 1 USD) if it lands on tails. There is a 50% chance of each outcome and thus the expected gain is: If the expected gain were greater than zero, the player would have an advantage. Similarly, if the expected gain were less than zero, the player have a disadvantage. Now say that the game involves rolling a six-sided die in which the player wins with a roll of 6 and loses otherwise. The game is fair when wins pay five times more than losses, because the expected gain in that case is: Fair Tontines In a tontine, investors lose their balances when they die. Our objective, then, is to design a tontine such that the expected incremental gain to survivors fairly offsets the amount lost when they die. Keep in mind that this “tontine gain” (sometimes referred to as longevity credits) is an additional amount received above and beyond any underlying investment returns. The intuition for how this must be accomplished is remarkably similar to the simple games discussed earlier. Let’s label a member’s account balance (i.e., the amount they have at stake) s, the probability that the member dies in the current month q, and the required tontine gain c. Fairness requires that: The left side of this equation represents the expected value of losses this month due to the risk of dying. The right side of the equation represents the required amount that the investor must expect to gain this month by surviving. Solving for c, we get: The quantity c represents the tontine gain, and q/(1-q) represents the tontine gain rate. As with flipping a coin or rolling a die, the gain received qs/(1−q) is simply the gain rate (i.e., the winning payoff rate) times the stake. Insights Perhaps the most interesting insight we can make here is that the fair tontine gain of every member is a function only of that member’s own probability of dying q and amount invested s. This fact comes as a surprise to many who may be inclined to ask, “Hey wait a minute… I don’t want to be in a tontine with a lot of younger people, do I?” Well, not if the tontine is designed unfairly! But the q’s and s’s of the other members won’t matter if the design is fair. And that is why fair design is so important. At this point you might be saying to yourself, “Hey, wait another minute… what about adverse selection? Isn’t it true that only those who believe they have average or better life expectancy are likely to invest?” The answer is yes, but keep in mind that tontine designers will use mortality rates that reflect this. The same is true of insurance actuaries whose job it is to price and set reserves for annuities. If you and I are different ages or different genders, our life expectancy will differ. Since a 90-year-old has a higher risk of dying next month than a 60-year-old, the 90-year-old must therefore receive a higher proportion of the tontine gains per dollar invested. Accordingly, members will expect to receive an increasing proportion of tontine gains per dollar invested as they grow older. Another important insight is that tontine investments are scalable in that the gains and losses are a linear function of the amount s that each member places at stake. Is It Really This Simple? Conceptually, yes. Tontine design does involve a lot of little details, but the good news is that when all the details are properly considered, fair and equitable tontine design is indeed possible.

We are pleased to announce the CFA Institute Research Foundation has published Tontines: A Practitioner’s Guide to Mortality-Pooled Investments, a first of its kind primer for investment practitioners on the subject of tontine portfolios. Many thanks to the Foundation for funding this research brief. Available at/on: CFA Institute Research Foundation Kindle Apple iBook Google Play​ Table of Contents: Preface Acknowledgements What Is a Tontine? Why Study Tontines? Longevity-Risk Pooling A (Very) Brief History of Tontines Are Tontines Legal? Literature The Fair Tontine Principle Fair vs. Equitable Mortality Rates Forfeiture Allocation Risk Pool Ownership Constraint Tontines Compared with Traditional Investment Portfolios Tontines Compared with Income Annuities Tontine Payouts Structured Payouts Tontine Accounting Illustrated Tontine Structures Additional Topics Conclusion References

Consumer choice is good for society. Let’s bring tontines back, better than ever. Richard Fullmer authored this piece published in Forbes in conjunction with the Wharton Pension Research Council of the University of Pennsylvania, which is committed to generating debate on key policy issues affecting pensions and other employee benefits.

The term “tontine” may be new to many people. This is not surprising, given that the once-common term largely fell out of use around one hundred years ago. Let’s review what a tontine is and take a quick look at its history… and why it is making a comeback. What is a Tontine? Quite simply, a tontine is an investment scheme combined with a particular payout scheme. Monies are invested and paid out according to the tontine’s governing documents. The key differences between a tontine and an ordinary investment fund in which you might choose to invest are two-fold. First, an investment in a tontine is generally (although not necessarily always) irrevocable. Second, monies invested in a tontine are not transferred to an investor’s heirs or other designated beneficiaries upon death. Rather, such monies are apportioned to the other living members of the tontine. Thus, monies that are forfeited by those who die are credited to those who live, increasing the return that is enjoyed by the surviving members. These extra returns are often referred to as “longevity credits.” The idea behind irrevocability is to ensure that surviving members will actually receive these longevity credits. After all, if members were allowed to freely withdraw all their money from the tontine while still living, there would be nothing to transfer when they eventually die. With a tontine, then, you give up the ability to withdraw from the scheme at will, but you gain longevity credits on top of the scheme’s underlying investment returns. As a result of gaining longevity credits, tontines can pay out to survivors significantly more than an ordinary investment fund. Furthermore, tontines can be designed to provide lifetime payouts, making them a great alternative for retirees. A (Very) Brief History of Tontines Tontines were first conceived and organized in the 17th century largely as a way for governments to fund wars. These “ancient” tontine schemes typically had lottery-like elements to them. In addition to some modest amount of interest, the tontine would grant very large windfalls to the lucky few who were lucky enough to outlive the other investors. Before long, entrepreneurs began to realize that tontines could be private ventures and redesigned to provide higher payouts in the early years with less of a last-survivor take all windfall at the end. In other words, they could be transformed from lottery-like to pension-like. The insurance industry took up the idea and began selling these new types of tontine schemes, which became very popular. Unfortunately, some insurance providers proved to be bad actors, finding ways to effectively defraud investors through self-dealing practices. For example, one provision that served to benefit insurance companies at the expense of investors was so-called “deferred dividend” policies that paid nothing for the first few years, but required the investor to continue making periodic investments or face losing their entire investment. Furthermore, amounts forfeited this way would often go to the insurer rather than to the other investors of the tontine. After receiving complaints, regulators moved to disallow the sale of such deferred dividend policies and tontines soon fell out of favor. In the 21st century, however, academics and others have called for the return of tontines. Benevolent tontines designed and managed under a trust law with all the modern techniques used by ordinary investment funds to prevent fraud. In addition, newer technologies in existance today can ensure the accurate operation of a tontine scheme with complete transparancy down to each and every transaction. In short, the reasons that led to the disallowance of tontines a century ago no longer exist. Tontines versus Annuities Pension-like tontines exhibit many of the characteristics of payout income annuities. The primary difference is that annuity income is guaranteed by an insurance company, who charges for this. Guarantees are not needed in tontines because the investors share risks among themselves by way of transferring the balances of those who die to those who survive. Because the rate at which people die is not certain, the longevity credits that a tontine investor expects to receive will experience some variability. However, if the number of investors in the tontine pool is sufficiently large, this variability is likely to have only a small effect on a tontine’s payouts. Thus, tontine investors gain by avoiding expensive guarantee charges that are inherent to annuities. Tontines Today Many types of tontine schemes are possible. Tontines may be lottery-like, pension-like, or exhibit elements of both. Because retirees are likely to need pension-like income, pension tontines may become an especially attractive market.