The Case for Tontine Pensions as a Lifetime Income Solution for State-Sponsored Retirement Savings Programs
By Richard K. Fullmer and Jonathan Forman
The quest for retirement security faces significant challenges in virtually every country around 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 increase the cost of financing retirement. This cost involves a number of assumptions, and each assumption involves 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 employer-sponsored retirement savings plans the ability to save with 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” differentiates 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 DB 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. This pools individual longevity risks and spreads out those risks among all of the tontine pension members rather than individuals bearing them alone. An investor’s tontine pension account is forfeited at 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 in 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. 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. In fact, 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 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 the founder of Nuova Longevità Research.
Jonathan Barry Forman is the Kenneth E. McAfee Centennial Chair in Law at the University of Oklahoma College of Law.
August 2020, 20-10
Fullmer, Richard K. and Forman, Jonathan Barry, “State-Sponsored Pensions for Private Sector Workers: The Case for Pooled Annuities and Tontines” (July 24, 2020). Wharton Pension Research Council Working Paper No. 2020-17.
Forman, Jonathan Barry and Sabin, M.J., “Tontine Pensions” (2015). University of Pennsylvania Law Review 163(33): 755−831.
Fullmer, Richard K., “Tontines: A Practitioner’s Guide to Mortality-Pooled Investments” (2019). CFA Institute Research Foundation Brief. Charlottesville, VA: CFA Institute Research Foundation.