Richard K. Fullmer is Founder of Nuova Longevità Research and Co-founder of Nuovalo Ltd. His research interests include longevity risk sharing, pension finance, and pension reform. John A. Turner is the Director of the Pension Policy Center. His research interests include pension and Social Security policy in the U.S. and other countries.
With the decline in defined benefit plans and growth of defined contribution retirement plans around the world, workers increasingly face the daunting task of managing the drawdown of their retirement plan assets during retirement. Many options have been developed to help retirement plan participants achieve good outcomes in the accumulation phase, yet employers, financial service providers, and policymakers can do more to assist them in the decumulation phase. This blog addresses that challenge.
We believe there could be an expanded role in this arena for robo advisors. Robo advisors are a relatively new development, which provide financial advice and manage investment portfolios using online software. In the U.S., they typically charge around 25 basis points a year and thus are substantially less expensive than human financial advisors, which typically charge around 100 basis points a year.
There is also a role for modern tontines, which are financial products with a long history. These are a type of hybrid pension arrangement. Like a defined benefit plan, they pool and diversify mortality risks across participants and pay out a stream of income for life in retirement that serves as an alternative to annuities. Tontines differ from defined benefit plans and annuities because they are not guaranteed and therefore charge lower costs. The benefits they provide vary over time, depending on members’ mortality experience and the financial market experience of the investments.
Modern tontines are similar to participating annuities, such as those offered by the insurance company TIAA, in which the participants bear investment risk and some or all of the mortality risk. Our proposal differs in that robo tontines would be considerably more customizable.
In a tontine, if more (fewer) of the participants die than expected, the benefits of the remaining participants increase (decrease). Likewise, if the investments do better (worse) than anticipated, benefits paid to the remaining participants increase (decrease). Because there is no guarantee (which is expensive to provide), tontine income streams are variable and thus riskier than fixed annuities which are often stable in nominal dollars, but they also can pay out more than fixed annuities due to their lower costs.
Automatic adjustment mechanisms are a way of maintaining solvency in retirement income products. With no adjustment mechanism, fixed annuities can face solvency risk and must therefore be invested conservatively. This insolvency risk is presumably small with the help of state reinsurance, but some people may overestimate the risk and others may be uncertain as to its level. Conversely, tontines do not face solvency risk because their payouts adjust automatically to assure solvency; thus, tontines can offer greater investment choice. Tontines can also offer greater fee transparency than annuities. For these reasons, tontines arguably have a place in the provision of retirement income.
We propose a combination of these two innovative financial products, in the form of robo tontines, which would be tontines provided by robo advisors. We believe that robo advisors would be well-suited to provide tontines for both supply and demand reasons. Robos are skilled in developing and managing financial products (supply), and they have clients who need help with the drawdown phase of their retirement investments (demand).
As well, robo tontines could resolve the agency problem that financial advisors may face due to conflicts of interest. That is, many advisors are disincentivized to recommend annuities (i.e., guaranteed lifetime income solutions) to their clients, when they are compensated based on the assets they manage. Annuities would entail a loss of assets to life insurance companies. With tontines, by contrast, robo advisors could offer an assured lifetime income solution while continuing to advise on the asset investments.
Because tontines have payout features like annuities, robo advisors could offer tontines with immediate payouts, deferred payouts, and payouts deferred to advanced older ages, called longevity insurance annuities. Robo advisors could offer tontines as an option for their clients for the post-retirement distribution phase, but they could also be offered during the pre-retirement period – for example, as part of a robo target date strategy with payouts deferred to retirement. Such tontines could be provided through employer-provided defined contribution plans, in which case they would be unisex tontines (at least in plans regulated by ERISA which requires unisex rating). Alternatively, they could be provided through Individual Retirement Accounts (IRAs) or outside pension plans, in which case they would probably be provided on a gender-specific basis. This is the same as with annuities, which are provided on a unisex basis through ERISA pension plans but generally on a gender-specific basis outside of those plans.
Robo advisors have experience in selecting and managing investments for clients. Most already manage a large number of individual accounts and have clients likely to need help managing the drawdown of their assets in retirement. This implies that they already have the scale necessary for efficient longevity risk pooling. Robo advisors are also financial technology innovators that have the basic technical skills to manage tontines. While some may lack the actuarial skills necessary to develop a system for redistributing longevity credits in an actuarially fair manner, this could be readily obtained by hiring or outsourcing the longevity risk administration to specialist providers.
Tontines could fit in well as part of a drawdown strategy and indeed might be preferred by many robo advisory clients for their assured sustainability, relatively low cost, and higher payout expectations. Robo tontines could be structured to help retirees deal with required minimum distributions (RMDs) they must take once they reach age 72. Alternatively, robo tontines could be structured like longevity insurance annuities, providing benefits starting at advanced ages, such as age 82.
Robo advisors are technology-based financial innovations that are already managing money for thousands of people. They have the financial skills to provide tontines as well as the client base. We believe this new product can assist clients with the drawdown of their retirement assets in a way that offers secure lifetime income. Moreover, tontine administration could be highly automated and designed to offer individualized investment strategies and payout options, in line with the robo advisor business model.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.