Tontine Pensions Professor Jonathan Barry Forman University of Oklahoma College of Law for Public Funds Summit East Newport, Rhode Island July 20, 2015.

Tontine Pensions

Professor Jonathan Barry FormanUniversity of Oklahoma College of Law

for

Public Funds Summit East Newport, Rhode Island

July 20, 2015

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Tontines

• Investment vehicles that combine features of an annuity & a lottery

• Investors pool their money– Each year they are alive, members share in the

investment income– As members die, their shares are forfeited to the

surviving members (“mortality gains”)

• Unless the fund is divided earlier, the entire fund goes to the last survivor

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Example 1• On the TV show, M*A*S*H,

Colonel Sherman T. Potter, as the last survivor of his World War I unit, got to open the bottle of cognac that he and his buddies got in France– and share it with his Korean

War compatriots

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Example 2

Steve and Mark are camping when a bear suddenly comes out and growls.

Steve starts putting on his tennis shoes.Mark says, “What are you doing? You

can’t outrun a bear!”Steve says, “I don’t have to outrun the

bear—I just have to outrun you!”*

* Boys’ Life, You can’t outrun a bear, http://boyslife.org/jokes/6953/you-cant-outrun-a-bear/ (last visited Mar. 5, 2015).

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Ex. 3: A Simple Tontine Fund

• Imagine a fund with 4 investors of different ages & each contributes $1000

• When one dies, each survivor gets $333.33$333.33 = $1000 ÷ 3

• Unfortunately, this simple approach can be unfair, because it favors younger investors– who are likely to live longer & so get more

distributions than older investors

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Example 4: What Would Be Fair?

• Imagine that our 4 investors are ages– 65, 70, 75 & 80

• Let’s make it a fair bet for everyone

• Start with death probabilities (qi)– The probability of dying within the next year– These come from a life expectancy table

• Use these death probabilities (qi) to derive “fair-transfer-plan weights” (wi) to divide the accounts of those who die

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Ex. 4: Fair Transfer Plan Weights

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Member Age

Life Expectancy

(years)

Death Probability

Fair-Transfer-

Plan Weight

1 65 18.88 0.013181 0.0538152 70 15.22 0.020314 0.0861833 75 11.89 0.032111 0.1467954 80 8.95 0.051906 0.713207

• For example, 65-year-old member 1:o has the longest life expectancy ~ 19 yearso has the lowest death probability ~ 1.3%o therefore, has the smallest fair-transfer-plan weight ~ 0.05

Example 4: A Fair Result

• For example, suppose member 4 (the 80-year-old) is the first to die

• Her $1000 would be distributed as follows:– 65-year-old member 1 gets $ 187.64– 70-year-old member 2 gets $ 300.51– 75-year-old member 3 gets $ 511.85– 80-year-old member 4 loses $ 1000.00

• It’s a fair bet for all

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Tontine Annuities and Pensions

• Tontine funds could be perpetual, with new investors coming in all the time

• Tontine funds could be used to create low-fee tontine annuities and tontine pensions

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Example 5: Replacing CalSTRS

• CalSTRS traditional defined benefit plan– B = 2% × years of service × final average pay• normal cost ~ 17% of compensation

– Only ~ 67% funded• unfunded liability ~ $74 billion (another 15% of

compensation)

• Partial solution: freeze the defined benefit plan & add a new tontine pension for future benefit accruals

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Several Major Advantages of Tontine Pensions

• Unlike traditional pensions– Tontine pensions are always fully funded– Sponsors face no actuarial or investment risks

• Tontine pensions resemble actuarially-fair variable life annuities– Could be run by a low-fee discount broker– No insurance profits or reserves– Therefore, significantly higher benefits to

retirees than with commercial annuities

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More Advantages

• Tontines would be popular– E.g., a tontine for a team of firefighters will be

perceived as fairer than a commercial annuity• With a commercial annuity, an early death seems to

benefit the insurance company, but with a tontine pension, an early death benefits fellow firefighters

• Tontine pensions and annuities could be regulated & protected by fiduciary rules

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About the Author• Jon is the Alfred P. Murrah Professor of Law at the University

of Oklahoma College of Law; he is the author of Making America Work (Urban Institute Press, 2006) and Tontine Pensions, 163(3) UNIVERSITY OF PENNSYLVANIA LAW REVIEW 755 (Feb. 2015) (with Michael J. Sabin), http://www.pennlawreview.com/print/index.php?id=468.

• Jon can be reached at [email protected], 405-325-4779, www.law.ou.edu/faculty/forman.shtml.

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