Richard K. Fullmer is the founder of Nuova Longevità Research. Jonathan Barry Forman is the Kenneth E. McAfee Centennial Chair in Law at the University of Oklahoma College of Law. This blog draws on Richard K. Fullmer and Jonathan Barry Forman, State-sponsored Pensions for Private Sector Workers: The Case for Pooled Annuities and Tontines, Wharton Pension Research Council Working Paper (July 24, 2020).
Oregon, Maryland, and a number of other US states have recently created state-sponsored retirement saving plans to help millions of private-sector workers lacking pension coverage to save for retirement. While these programs offer a good way to accumulate retirement savings, people also need an efficient way to convert their retirement savings into lifetime income. To address this need, state governments would do well to investigate and potentially sponsor new, low-cost lifetime pension assurance funds.
An assurance fund would operate like mutual funds currently held within defined contribution (DC) plans, but with the added features of mortality risk pooling and fully-funded lifetime payouts. A DC plan could offer a few different assurance funds in the same way that it offers a few different traditional mutual funds. Moreover, the DC plan could use the same underlying investments for both. Participants could allocate their retirement contributions between regular mutual funds and assurance funds, however they wished.
Assurance funds would offer some of the same features as traditional defined benefit (DB) pensions, such as mortality risk pooling and lifetime payouts. A big difference, however, is that their sponsors would not promise a specific benefit level, and thus they would avoid incurring any defined benefit liabilities. In short, assurance funds would not operate as DB pensions, but rather as tontine pensions (or, alternatively, as pooled annuities).
A tontine is a financial arrangement that operates according to the survivor principle: the assets of those investors who die are enjoyed by those investors who survive. To illustrate, imagine that 1,000 65-year-old retirees each contributed $1,000 to a tontine that purchased a $1,000,000 Treasury bond paying two percent interest coupons. The bond then earns $20,000 interest per year, split equally among the surviving investors in the tontine. A custodian would hold the bond, and because the custodian takes no risk and requires no capital, the custodian would charge a trivial fee. If all investors lived through the first year, each would receive a $20 dividend from the fund ($20 = $20,000 / 1,000). If only 800 original investors were alive a decade later (at age 75), then each would receive a $25 dividend ($25 = $20,000 / 800). If only 100 of the original investors were alive two decades after that (at age 95), then each would receive a $200 dividend ($200 = $20,000 / 100), and so on. Basically, investor accounts are forfeited at death, and the proceeds are fairly apportioned among the surviving investors as “mortality credits.”
Of course, many retirees would prefer level benefits rather than benefits that increased exponentially toward the end of their lives, and that is where tontine pensions come in. In a tontine pension, payouts are designed to be level (including in real terms) rather than increasing exponentially over time, and the pension itself is subject to a strict budget constraint that requires the plan to remain fully funded at all times. To be sure, payouts would vary somewhat from month to month, based on actual investment performance and, to a far lesser extent, the collective mortality experience of the tontine members.
State-sponsored Lifetime Assurance Funds
A lifetime assurance fund is essentially a DC pension designed to pay out what it can—no more and no less—in an objective manner fully disclosed to all participants. The investment balance of each investor is accounted for individually and reflects actual market values. Contributions are irrevocable, to enforce the condition that the risk-sharing arrangement is for life. In return, investors receive both investment returns and mortality credits for as long as they live.
The term ‘assurance’ is used to differentiate these funds from ‘insurance’ products. By dispensing with the costs of insurance-company guarantees and reserves, assurance funds can be expected to generate higher average payout rates compared to commercial annuities. Moreover, since assurance funds make no guarantees, plan sponsors would bear no risks of underfunding.
All told, these state-sponsored assurance-fund pensions could provide lifetime income to millions of retirees. They could be operated much like today’s state-run 529 educational savings plans, where states typically contract with investment managers to offer several investment options for savers. Costs could be very low, perhaps as low as 30 basis points, consisting of around 10 basis points in fund management fees for assets managed passively and about 20 basis points for other administrative expenses. Tontine pensions may also be of interest outside the US as an efficient, low-cost way to provide access to assured lifetime retirement income, perhaps especially in countries where deep insurance markets do not exist.
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