In the city of Lancashire, which is in the northwest part of England, in the year 1581 a very wealthy landowner by the name of Alexander Houghton died without legitimate heirs to inherit his wealth and continue his title. He was a nobleman with a large estate, a household with over 30 servants and substantial income from his properties and investments. Alexander loved the arts, theatre and music and supported a troupe of players in a local acting company in Lea Hall, also in Lancashire.
So, although by law Houghton’s half-brother and brother-in-law inherited the estate, Alexander left provisions in his will that the servants be granted employment and permanent financial support. All in all, Houghton left a substantial sum to his devoted servants and employees. As anyone who has watched the PBS television show Downton Abbey can attest, the relationship between master and servant was quite close in England, having been developed over many generations.
However—and this is where things get relevant—Houghton didn’t quite hand over a lump sum of money to his favored group of servants. Instead, he set-up a (peculiar) retirement annuity for them.
First, the will specified that the annual rents from properties contained in the estate, amounting to about 330 shillings per year, be distributed among 11 of his most favored employees. The oldest was to receive £3 (which is 60 shillings) per year, the next oldest £2 per year, etc., all the way to the youngest who was to receive 12 shillings per year, for life. These sums might seem trivial by today’s standards, but in the mid-16th century the average industrial wage was £6 a year.
Now, at this point you might be wondering about the significance of a benevolent and childless English landowner, kind enough to grant a pension to his devoted employees when he died. But, you see, Houghton added a small provision to the will that made his generosity unlike any other pension you or your clients have ever seen.
I will quote directly (in more modern English) from the 1581 document.
“The portion of those that die shall be equally divided amongst those that shall survive, so that the final survivor amongst them shall have for his life the whole rent from the property.”
Effectively, when one of the 11 servants died, the annuity income he would have been entitled to—instead of going to spouses, and children, like today’s pension—would be redistributed to the other servants who were still alive. So, the annual pension of those who were still living would increase as other members of this very small group died off. A nice inflation hedge, if you will.
Why Houghton chose this particular structure—you die and I win—to disperse the assets in his estate isn’t quite clear. And, at first glance this might appear to be a most unfair and ghoulish arrangement. Why should the survivors benefit from the death of others? Shouldn’t the income continue to beneficiaries and loved ones? The cynical reader might worry about shenanigans to accelerate the demise of others (a.k.a. moral hazard).
But when you think about it very carefully and through the prism of financial economics, there are some good reasons why a pension annuity should be structured this way. It creates greater predictability of the liability, shares longevity risk across the cohort that stands to benefit the most and provides a natural inflation hedge. I will try to convince you that this is “optimal” in future writing and would be glad to reply to challenges. But, even if you disagree with the merits or fairness of such a scheme, it was Houghton’s will. He should be free to do with his wealth, income and property as he pleased, regardless of the perverse incentives it might create.
Enter the Tontine