Tontine Pensions: A Solution to the State and Local Pension Underfunding Crisis
Jonathan Barry Forman
University of Oklahoma College of Law
Michael J. Sabin
March 1, 2014
University of Pennsylvania Law Review, Vol. 163
Tontines are investment vehicles that can be used to provide retirement income. Basically, a tontine is a financial product that combines features of an annuity and a lottery. In a simple tontine, a group of investors pool their money together to buy a portfolio of investments, and, as investors die, their shares are forfeited, with the entire fund going to the last surviving investor. Over the years, this last-survivor-takes-all approach has made for some great fiction. For example, on the television show “Mash,” Colonel Sherman T. Potter, as the last survivor of his World War I unit, got to open the bottle of French cognac that he and his buddies bought (and share it with his Korean War compatriots). On the other hand, sometimes the fictional plots involved nefarious characters trying to kill off the rest of the investors and “inherit” the fund.
To be sure, a tontine can be designed to avoid such mischief. For example, instead of distributing all of the contributions to the last survivor, a tontine could make periodic distributions. Each time a member dies, her contribution would be distributed among the survivors. The tontine could solicit new investors to replace those that die. In that regard, elsewhere, one of us (Sabin) has described how these tontine funds could be used to create perpetual “tontine annuities” that could be sold to individual investors.
In this Article, we consider how the tontine principle could be used to create “tontine pensions” that could be adopted by large employers to provide retirement income for their employees. We also show that these tontine pensions would have several major advantages over most of today’s pensions, annuities, and other retirement income products.
At the outset, Part II of this Article explains how the current U.S. retirement system works and how retirees can use pensions, annuities, and other financial products to generate retirement income.
Next, Part III of this Article offers a step-by-step explanation of how tontine funds, tontine annuities, and tontine pensions could work today. Part III then compares tontine pensions with traditional defined benefit pension plans, with defined contribution plans, and with so-called “hybrid pensions” (i.e., cash balance plans). In particular, Part III shows that tontine pensions have the two major advantages over traditional pensions. First, unlike traditional pensions — which are frequently underfunded, tontine pensions would always be fully funded. Second, unlike a traditional pension — where the pension plan sponsor must bear all the investment and actuarial risks, with a tontine pension, the plan sponsor bears neither of those risks. These two features should make tontine pensions a particularly attractive alternative for employers who care about providing retirement income security for their employees but who want to avoid the risks associated with having a traditional pension.
Part IV of this Article then develops a model tontine pension for a typical large employer, and we use that model to estimate the benefits that would be paid to retirees. For simplicity, the model assumes that, each year, an employer would contribute 10% of salary to a tontine pension for each employee each year (in the real world, employers could choose to contribute a greater or lesser percentage of salary on behalf of their employees). The model generates tontine pension benefits for each retiree that would closely resemble an actuarially fair variable annuity (i.e. one without high insurance company fees [“loads”]). More specifically, unlike commercial annuities which must support insurance agent commissions and insurance company reserves, risk-taking, and profits; the management and recordkeeping fees involved with running a tontine pension would be minimal. That means that tontine pensions would provide significantly higher retirement benefits than commercial annuities.
Part V of this Article then shows how such a model tontine pension could be used to replace a typical, large traditional pension plan like the California State Teachers’ Retirement System (CalSTRS). Pertinent here, like so many other state-run pension plans, CalSTRS is underfunded; for example, as of June 30, 2012, the CalSTRS traditional pension plan was just 67.0% funded, with an unfunded liability of almost $71 billion. While replacing CalSTRS with a tontine pension would do nothing to reduce that $71 billion obligation, it would ensure that California would never again have to worry about underfunding attributable to future benefit accruals.
Finally, Part VI of this Article discusses how to solve some of the technical problems that would arise in implementing a tontine pension, and Part VII of this Article offers some concluding remarks.
Number of Pages in PDF File: 88
Keywords: pension reform, tontine, pension underfunding, annuity, variable annuity, expense ratio, state and local pension funding, defined benefit, defined contribution, pension debt, pension funding, CalSTRS, retirement income security, survivor benefits
JEL Classification: G22, G23, G24, H55, H62, H63, H72, H74, J26, K31, K34Accepted Paper Series
Date posted: February 10, 2014 ; Last revised: March 2, 2014
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