Tontine Pensions

Tontines are investment vehicles that can be used to provide retirement income. A tontine is a financial product that combines the features of an annuity and a lottery. In a simple tontine, a group of investors pool their money together to buy a portfolio of investments and, as investors die, their shares are forfeited, with the entire fund going to the last surviving investor. Over the years, this “last survivor takes all” approach has made for some great fiction. For example, in an episode of the popular television series M*A*S*H, Colonel Sherman T. Potter, as the last survivor of his World War I unit, got to open the bottle of French cognac that he and his buddies bought (and share it with his Korean War compatriots). On the other hand, sometimes the fictional plots involved nefarious characters trying to kill off the rest of the investors to “inherit” the fund. Of course, tontines can be designed to avoid such mischief. For example, instead of distributing all of the contributions to the last survivor, a tontine could make periodic distributions. Indeed, tontines could be used to create “tontine annuities” that could be sold to individual investors. These tontine annuities would make periodic distributions to surviving investors, but unlike traditional tontines, tontine annuities would solicit new investors to replace those that have died. Structured in this way, a tontine annuity could operate in perpetuity. In this Article, we consider how the tontine principle could be used to create “tontine pensions” through which large employers could provide retirement income for their employees. These tontine pensions would have several major advantages over most of today’s pensions, annuities, and other retirement income products. At the outset, Part I of this Article explains how the current U.S. retirement system works and how retirees can use pensions, annuities, and other financial products to generate retirement income. Next, Part II offers a step-by-step explanation of how tontine funds, tontine annuities, and tontine pensions could work today. It then compares tontine pensions with traditional defined benefit pension plans, defined contribution plans, and so-called “hybrid pensions” (e.g., cash balance plans). In particular, Part II shows that tontine pensions would have two major advantages over traditional pensions. First, unlike traditional pensions — which are frequently underfunded — tontine pensions would always be fully funded. Second, unlike a traditional pension — in which the pension plan sponsor must bear all the investment and actuarial risks — with a tontine pension, the plan sponsor bears neither of those risks. These two features should make tontine pensions a particularly attractive alternative for employers who wish to provide retirement income security for their employees but want to avoid the risks associated with a traditional pension. Part III then develops a model tontine pension for a typical large employer. We then use that model to estimate the benefits that would be paid to retirees. For simplicity, the model assumes that, each year, an employer would contribute 10% of each employee’s salary to a tontine pension (in the real world, employers could choose to contribute a greater or lesser percentage of salary on behalf of their employees). The model generates tontine pension benefits for each retiree that would closely resemble an actuarially fair variable annuity — i.e., one without high insurance company fees (“loads”). Specifically, unlike commercial annuities which must support insurance agent commissions, insurance company reserves, risk-taking, and profits, the management and recordkeeping fees associated with running a tontine pension would be minimal. That means that tontine pensions would provide significantly higher retirement benefits than commercial annuities. Part IV shows how such a model tontine pension could be used to replace a typical, large, traditional pension plan like the California State Teachers’ Retirement System (CalSTRS). Like so many other state-run pension plans, CalSTRS is underfunded; for example, as of June 30, 2013, CalSTRS was just 66.9% funded, with an unfunded liability of almost $74 billion. While replacing CalSTRS with a tontine pension would do nothing to reduce that $74 billion obligation, it would ensure that California would never again have to worry about underfunding attributable to future benefit accruals. Finally, Part V discusses how to solve some of the technical problems that would arise in implementing a tontine pension.