Using Tontines to Manage Longevity Risk the Natural Way
Updated: Jul 12, 2019
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 mortality 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” mortality risk without involving an insurance company as a middleman in the transaction. The tontine itself aggregates the individual mortality risk of its members, and does so every bit as effectively as an insurance company. To quote Michael Finke, dean & 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 mortality. 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 mortality-pooling collective in which members voluntarily aggregate and share individual mortality risks among themselves. This mortality pooling, combined with payout adjustments that maintain the pool’s fully funded status, effectively eliminates longevity risk for each member. Investment risk and aggregate mortality 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.
¹ “The Private Correspondence of Benjamin Franklin… Published from the Originals, by his Grandson William Temple Franklin”, Volume 1, Second edition, p. 266. https://books.google.com/books?id=jY8EAAAAYAAJ&pg=PA266
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.