Are tontines the solution to the decumulation conundrum?
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Tontines, an ancient form of mutual longevity insurance, could be making a comeback as the number of supporters is growing. Are tontines the answer to the pension world’s prayers or simply outdated?
Defined contribution is still a great experiment; while the accumulation phase of DC has now been dealt with at a basic level through auto-enrolment, decumulation still offers no solution that meets what members keep saying they want – a stable income at an affordable price. Could tontines be the answer to DC members’ problems?
‘Watch your back’ or forgotten genius?
Tontines are an ancient form of mutual insurance attributed to 17th century Neapolitan banker Lorenzo de Tonti, who worked on them in France, where tontines are still in use.
Similar to an annuity, they pool longevity risk by grouping people and their assets into a fund, paying out a regular sum based on age and contributions, and keeping any money that is left on someone’s death in the pool.
Unlike insurers, tontines do not guarantee the payments however – they can in principle go down as well as up – but modern tontines use actuarial calculations that ensure it is unlikely someone outlives their pot unless they reach the age of, for example, 120, while insurers would guarantee that it is impossible to ever outlive it.
Modern tontines exist also in Australia, where they are known as self-annuitisation funds, and South Africa but have gained a bad reputation in Europe and the US due to scandals and poor practice in their early history. Though not illegal, they have struggled to make a comeback, but their number of supporters is growing again.
Catherine Donnelly, associate professor at Heriot-Watt University and a fellow at the Institute and Faculty of Actuaries, is a proponent of the vehicles.
“Anyone who works on them [says], ‘Why wouldn’t you be offering them?’” she says.
Tontines address the issue of people not knowing when they will die whilst also not being interested in buying annuities – something referred to as the ‘annuity puzzle’, says Donnelly.
The higher income and lower cost of tontines could potentially overcome this, she believes, and end an unsatisfactory situation. “At the minute you don’t really know what to do with that money,” she says, criticising the fact that people are asked to take complex decisions at retirement.
“In a tontine there is risk on people, but the main risk is the risk of not knowing when you’re going to die. That risk is pooled in a fund just like an annuity,” she observes. As there is less in-built prudence and no Solvency regulations, this could be done at a lower cost than in an annuity.
Cost might however not be the only issue. With the advent of defined contribution, people’s focus has shifted from income to assets and investments.
“Coming up to retirement you’re sent a retirement statement; it talks about investment returns, so you think in an investment frame. So when you retire, you think, 'I’m going to live 15 years, so my return will be such and such, if I live 20-25 years I break even my annuity'. People think in a consumption frame, not [in terms of] income for life,” she argues.
Sceptics also often raise the bequest motive, arguing that people are reluctant to leave their pot with an insurer or a tontine instead of passing it to their heirs. Tontines can factor in inheritance, but the regular payments are smaller as a consequence. South Africa-based modern tontine Nobuntu pays half of what has been saved to a member’s family, for example, while others have modelled a tontine with a 20% bequest.
Tontine v CDC: A false dichotomy?
If a tontine is closed to new members when it has reached a certain size – as some tontines are – it will decrease and rapidly reach a volume where it is no longer viable, yet for Donnelly, the need to close down does not pose a major issue. "At some point there will be too few people, but the idea is that before that point is reached, there would be well defined options for how to continue that income,” she says – for example transferring to an insurance company or receiving a lump sum of what is left in the fund.
However, she emphasises that tontines do not need to be closed but can be open. “In fact, they should be open to new members to reduce income volatility, as papers that study open tontines show,” she says.
Critics have argued that tontines closing a pool of similar members is a potential weakness. For David Pitt-Watson, fellow at Cambridge University’s Judge Business School, the longevity of the vehicle itself should be guaranteed – by a stream of new members. This flow of new joiners differentiates collective defined contribution schemes, as proposed in the pension schemes bill, from tontines, he says, while Donnelly calls such a differentiation “a false dichotomy”.
Pitt-Watson calls tontines “an inefficient mechanism” for sharing longevity risk, because “as members of the tontine die, the calculation of their average longevity gets less accurate; the types of investment change; the administrator has less money under management and fewer fees, so less interest in good management”.
In contrast, he says, CDC “allows everyone to join the pension plan, with the aim of providing an income until the day they die".
However, in their current proposed form – attached to a single employer – a CDC scheme could itself become a tontine if the employer ceases to trade and thus no new members are joining, he admits, but is of the view that it is more likely the scheme would be merged into another scheme instead.
CDC has previously come under fire for the risk of intergenerational transfer of wealth, as young people might be supporting the benefits of older generations to later see their own benefits cut if it turns out that the scheme's funding level has dropped.
Pitt-Watson says that while this risk exists, it is less pronounced than in current forms of pension provision. “As the future unfolds, young people may end up with a somewhat better or worse outcome than older ones. But all studies show that CDC creates much less volatility in outcome than buying an annuity, because annuity prices vary so much over time,” he argues, meaning different cohorts pay very different prices for the same level of income.
‘Live long and prosper’
However, others see an opportunity in young people's fear of being short-changed. The issue of intergenerational fairness is one of the reasons Dean McClelland is planning to launch TontineTrust – a modern tontine that plans to pool members with similar demographic characteristics and contributions and close these pools once they reach a certain size, for example 10,000 members.
“We could launch tomorrow, but we wouldn’t have the PEPP label. That’s what we want, it’s the gold standard of pensions now,” says McClelland. “We want people to understand it’s not some new obscure thing.”
He claims tontines increase members’ equity wealth without added risk, whereas annuitants are exposed to an insurer’s balance sheet risk – saying that insurers are not as stable as they seem.
Investment risk would also be relatively low. “A lot of pension funds are reliant on returns of 7.5% to get back to being fully funded. If we get a gross 4.5%, net 3.5%, we’ll be doing fantastically,” he says.
TontineTrust aims to charge a 1% all-in fee to members, equivalent to the cap set in Eiopa's draft regulations for the PEPP.
Given that those living longest will receive more from the tontine, his trust's trademarked motto is, ‘Live long and prosper’.
Tontines are a way of addressing the risk of people outliving their wealth, and their fear of doing so, he argues. “People out there at the moment are terrified of living longer. It’s like a game of Russian roulette.”
Are tontines a better way to offer DC decumulation?