Tontines Could Be The Future Of Retiring

By Vaidyanathan Ravichandran

The history of the tontines

Over 100 years ago in America there was a ludicrously popular (and somewhat sleazy) retirement scheme called the tontine.

Tontines have a history that reaches back at least half a millennium. The name comes from an Italian financier, Lorenzo de Tonti, who famously pitched a tontine scheme to the French government in the 17th century, as a way for King Louis XIV to raise money.

Back then, if you paid the king 100 pounds, he might promise to pay it all back to you with interest over the course of a dozen years — that would be a bond. Or the king might make small annual payments to you and descendants for the rest of eternity — that would be a perpetuity. Or the king might make you slightly larger annual payments until you died — that would be an annuity.

Tontines were a very popular twist on the annuity because they appealed to the gambling spirit.

Tontines, you see, operate on a morbid principle: You buy into a tontine alongside many other investors. The entire group is paid at regular intervals.

The key twist: As your fellow investors die, their share of the payout gets redistributed to the remaining survivors.

In a tontine, the longer you live, the larger your profits — but you are profiting precisely off other people’s deaths. For this reason, even in their heyday, tontines were regarded as somewhat repugnant.

An annuity would pay you a steady trickle of money (boring). A tontine would pay you more and more as time went on because other people would be dying and you would be accumulating their shares.

It was the ultimate lottery. If you died early, you stood to lose. But if you were the last person standing, you stood to collect huge annual payments.

Tontines came to America in 1859, nearly 200 years after their birth in Europe. Henry Hyde, who founded what is now the insurance company AXA Equitable Life, designed a hybrid tontine that blended life insurance with a retirement scheme. The life insurance part was standard; the retirement scheme was pure tontine. As people got older and older, their retirement payments would escalate as more of their peers died.

At their peak, in the 1880 s, tontines represented nearly two-thirds of the American insurance market, holding about 7.5 percent of national wealth. It’s estimated that by 1905, there were 9 million tontine policies active in a nation of only 18 million households. Tontines became so popular that historians credit them for single-handedly contributing to the growth of the American insurance industry.

But what makes their history interesting is that the downfall of the tontines was equally dramatic. Not long after 1900, a spectacular set of scandals wiped the tontines from the nation’s consciousness. To this day, tontines remain outlawed, illegal and their name is synonymous with greed and corruption. Their memory lives on only in fiction, where they invariably propel some murderous plot.

How did the tontines become so popular?

The tontine came to America at a critical moment. The American economy was rapidly industrializing, which was creating a new problem: What to do with all the old people?

In the agricultural economy, the system to support people in old age was children. Children were expected to take care of their elderly parents. That was not so difficult when parents lived with their children and could also help out with light work around the farm.

But the new urban factory jobs were completely different. These were often debilitating, strenuous occupations. People couldn't work in their old age.

As families started to disperse, cultural attitudes about family obligations began to change. The new ethic was that a man wasn't going to be a burden on his children. He was going to take care of himself.

But how? There were banks, but the interest rates were disappointing. Furthermore, there was the fear that a man might outlive his savings. The tontine, which offered to pay you until you died, was a comforting guarantee. The fact that the payments would grow over time was an added perk.

What then led to their downfall?

The popularity of tontines would be their downfall. Tontines raised so much money for insurance companies that the industry attracted intense scrutiny. Much of the suspicion was not unwarranted.

According to critics, tontines characterized gambling, in as much as the only hope of profit to a few is that the many will be robbed of their savings. There were a lot of frauds and mysterious deaths and the needle of suspicion pointed at tontines!

Finally, in 1906, New York state launched a major investigation into the insurance market that resulted in the banning of tontines. Soon, other states were passing their own bans, and the tontine would not be heard from again.

Why is there a clamour for a comeback?

Now, more than over 100 years later, contemporary economists argue that this was an overreaction.

A growing chorus of economists and lawyers is wondering if the world wasn’t too hasty in turning its back on tontines. These financial arrangements, they say, have aspects that make a lot of sense despite their history of disrepute.

Considered as a financial innovation, the tontine was very successful. Considered as insurance, it was actuarially sound. Considered as a gamble, it was a fair bet in as much as there was no percentage for the house beyond a charge to cover administrative costs. Considered as a life-cycle asset, it proved to be an excellent investment, earning a rate of return substantially in excess of that generally available on other assets.

How does a tontine score over an annuity?

The demise of the American tontine gave rise to another peculiarly American institution: the corporate pension. But today, with pensions on the decline, there are few guarantees left in modern retirement. A common headache is figuring out how slowly retirees should spend their nest eggs. No matter how frugally they live, there’s always the risk that they’ll survive surprisingly long and end up utterly broke.

Economists have long said that the rational thing to do is to buy an annuity. At retirement age, you could pay an insurance company Rs. 25,00,000 in return for some Rs. 100,000 -125,000 a year in guaranteed payments until you die. But most people don’t do that. For decades, economists have been trying to figure out why.

Economists who have extensively studied American retirement, say it’s still a mystery why annuities are so unpopular. A number of theories have been advanced — people might like to leave some money for their children, or they might worry about medical expenses late in life.

There’s also a theory and even some evidence that people just irrationally dislike annuities. Rather than viewing an annuity as providing insurance in the event that one lives past 85 or 90, most people seem to consider buying an annuity as a gamble, in which one has to live a certain number of years just to break even.

Here is where tontines come in. If people irrationally fear annuities because they seem like a gamble on one's own life, history suggests that they irrationally loved tontines because they see tontines as a gamble on other people's lives.

A simple modern tontine might look like this: At retirement, you and a bunch of other people each chip in Rs. 500,000 to buy a bouquet of mutual funds or stocks or whatever. Every year, the group withdraws a predetermined amount and divides it among the remaining survivors. You might get a bonus one year, for instance, because Amar, Akbar and Antony died.

Supporters of tontine argue that such an arrangement can feel more psychologically fair. Retirees often object to annuities because they worry about not living long enough to make the money back.

To think about it a different way, a tontine is like an annuity in which the middleman has been cut out - another advantage that tontines have over annuities, proponents say.

Annuities are expensive to administer, and so their payouts are rather low. The costs stem in part from paying the insurance company to shoulder all the risk. To guarantee it can make good on all its annuity contracts, the insurer has to set aside a lot of money in reserve — just in case people live longer than expected, or in case the market crashes.

A tontine does away with all that overhead, so more money is available to the retirees. A back of the envelope calculation indicates that a tontine might offer a 10 % to 20 % premium over an annuity — a bigger pie to be divided among the group. The downside is that retirees would see their payouts fluctuate depending on the various times other people in the tontine group died.

Supporters of tontine recently made the case that existing large pension organizations might switch to a tontine-like model. Instead of setting aside so much money to make sure all the pensions are fully funded, why not let the pension payouts vary? If people are dying faster than anticipated, redistribute their shares so that the remaining pensioners get slightly larger cheques. If people are dying slower than anticipated, shrink those pension cheques a bit.

Such a system would be cheaper to operate and would always, by definition, be fully funded. The funny thing is that some retirement systems already carry out a version of that process. There is "tontine thinking" embedded in certain pension schemes. These plans adjust payments according to mortality. They just don't use the word tontine.

Tontines are a bit like the dinosaurs of the retirement world. They perished in a dramatic extinction event, but their DNA lives on in many of the financial products we see today. Tontines were some of the first popular ways to save for retirement, and historians say their demise left the door open for corporate pensions, and Social Security, which continued the tontine promise of a guaranteed retirement.

Economists argue that it's time for tontines to return again on the private market. They envision tontines competing against annuities and longevity insurance and all the other products available to people hoping to smooth out the last stretch of their lives. They are certain many people would find them appealing. Tontines give people a choice at retirement.

Think of a fashion show. You will notice stunning models walking down the ramp in outrageous outfits that make you wonder ‘Who would wear such a thing?’ And the answer is pretty much nobody. But watch and see how next season some of the patterns and themes from that shocking display filter down to clothes everyone is wearing.

The tontine is the extreme longevity insurance product which walked down the ramp 350 years ago… and should be invited back for an encore. You might not be interested in buying one, but the idea is to get ‘tontine thinking’ to filter through to next season’s insurance products. Tontines could be the future of retiring.

Acknowledgements:

1. Moshe Milevsky, professor of finance at York University, who has authored a book on tontines.

2. Richard Sutch and Roger Ransom, economic historians who have several published papers to their credit.

3. Druce Vertes , Founder , StreetEYE.com

By Vaidyanathan Ravichandran