In his new book, “King William’s Tontine: Why the Retirement Annuity of the Future Should Resemble Its Past,” Moshe Milevsky argues convincingly that retirees have a product problem. Today’s financial marketplace of investment and insurance products doesn’t offer the perfect solution. To find that solution, he goes on an archeological dig in Renaissance Europe and unearths the tontine. Cast away years ago, the tontine may hold secrets to solving the income puzzle faced by retirees looking for a private sector solution to replace employer pensions.
King William’s tontine was originally dreamed up as a lottery-like bond scheme meant to fund the king’s war spending issues. The tontine bond provided bond interest payments until death. There was also the possibility of huge payments to those who lived a long time since the total interest amount was shared among the survivors until the last one died.
Although the king’s tontine might not sound like the perfect way to fund retirement income, it contains a number of features that could be resurrected to provide retirees with greater financial security.
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. When retirees share the risks of living longer than expected, or of facing low portfolio returns, they are better off than if they face these risks alone. As we learned in kindergarten, the idea of sharing can be painful at first. But sharing retirement wealth with others underlies what Milevsky terms “tontine thinking.”
Tontine thinking throws out some of the promises employers and insurance companies make to workers. That’s because making promises means predicting how long retirees will live and what investment returns will be in the future. Unfortunately, actuaries don’t have a crystal ball. They have data on past mortality rates and asset returns. But what if there’s a cure for cancer? Or a 21st century plague? Or a sustained low interest environment? In each case, the estimates could be wildly off.
Institutions making future income promises will either face a shortfall, or they’ll be flush with cash that could have been used to pay higher incomes. Neither is ideal.
At a recent Wharton Pension Research Council meeting, a European panelist argued that he “didn’t want to live in a world where we couldn’t guarantee an income to retirees” in response to a question (by me) about whether workers shouldn’t face an income haircut if bond and stock returns didn’t turn out as well as the pension anticipated. The problem with his response is that somebody will have to pay when the assumptions used to estimate the guarantees don’t pan out.
Milevsky deals head on with the moral implications of a pension scheme that doesn’t involve risk sharing among peers. When pensions or insurance companies make income promises based on optimistic assumptions, someone has to pay when reality doesn’t measure up. If you’re an insurance company, this means the very real risk of insolvency that many faced after making generous income guarantees of GMWB policies before the financial crisis. If you’re a private pension, this means increasing contributions or reducing benefits of younger workers, which involves a wealth transfer from younger to older participants. If you’re a government, then you’re tempted to promise big guarantees to older citizens at the expense of younger taxpayers who either don’t, or can’t, vote.
The reasonable response of insurance companies is to face these risks by increasing the cost of annuities. This involves increasing expenses, holding back greater reserves or providing far more modest guarantees. While a fair market price is more likely to provide a sustainable pension system, it also means that retirees will need to pay more to transfer this risk to an institution. Like any insurance product, it sacrifices expected wealth for security.
The Jared Tontine
Milevsky seeks to address what he calls “the plight of Jared”—referring to the Bible’s second-oldest person (his lifespan was exceeded by that of his better-known grandson Methuselah). Jared, he explains, is his euphemism for the many retirees who will live to advanced ages without breaking records or even being considered all that unusual—and who will have to pay for their extended retirements.
“Yet,” Milevsky writes, “no insurance company, retirement system, or pension plan can afford to support all these Jareds, especially considering how little we have collectively saved for retirement.”
Milevsky’s solution pulls together some of the best ideas from existing products using economic theory and past experience to weed out ideas that don’t work. These include complexity and a lack of risk sharing in annuities, historical tontine features that don’t make much economic sense such as those in King William’s tontine, and the lack of mortality pooling in investments. This means starting with a shell of a tontine and tweaking the rules to create a more perfect retirement product.
To understand why “tontine thinking” makes sense, it’s important to revisit the benefit of pooling longevity risk among retirees. Today’s retirees often draw from a lump sum of money in a defined contribution plan to fund retirement income. Even if they place their savings in safe investments and withdraw their money prudently so it will last, they are taking two very important risks that can be reduced by pooling.
The first risk is that they’ll live too long. We know that a proportion of today’s retirees will live to 100. If you carefully ladder a bond portfolio to cover expenses up to age 100, what happens if you live to 105? It’s not easy to plan when you don’t know your time horizon. This is longevity risk, or more accurately idiosyncratic longevity risk (or retiree-specific longevity risk).
All retirees who don’t pool their savings face this idiosyncratic risk and must deal with it by spending very little to avoid running out of money, or by spending more and taking the risk that they’ll have to cut back if they beat the odds.
I’ve just alluded to the second risk. A retiree who wants to avoid running out of money can assume an extended lifespan, say tailoring an investment portfolio and withdrawal strategy to last to age 105. How much, though, can retirees spend if they plan to live to 105? Not very much at all. If we assume an investment in safe bonds, they’d need to save perhaps 35 times their spending goal or more if they retire at age 65 and withdraw a tiny slice each year to cover living expenses.
Most retirees will die long before Methuselah or Jared. Dying early is great news for the (not emotionally attached) heirs, but it isn’t so great for the retiree. This creates the great tradeoff of pooling retirement savings. Pooling means more money goes to the retirees, and accepting idiosyncratic risk means more money goes to the children or charities of retirees (or means that the retiree runs out of money early). Since Milevsky is an economist, he believes that pooling is a better deal.