Feasibility and Welfare Impact of Flexible Tontine Design

Abstract

The feasibility and welfare impact of allowing flexible payouts in a tontine is investigated, including the impact of adverse selection by pool members after joining the pool. This is achieved by simulating an open tontine with consistent membership numbers, considering two different mortality credit distribution mechanisms. Changes in payout levels between periods are analysed across three components relating to investment uncertainty, systematic mortality uncertainty and idiosyncratic mortality uncertainty. Certainty equivalent payouts are used to measure welfare loss compared to an equivalent actuarially fair annuity. In the base scenario, the group-based distribution mechanism is preferred, with welfare loss of 0.41% compared to the equivalent annuity, of which four-fifths is due to systematic mortality uncertainty and one-fifth is because of idiosyncratic mortality uncertainty. Potential adverse selection can also cause welfare loss and lead to a preference for a cohort-based distribution mechanism; with appropriate constraints this welfare loss is smaller than the loading applied to an equivalent insured annuity. This investigation is presented in an administratively feasible structure and hence the key findings of this paper can be broadly applied by product providers keen to innovate.

Keywords: Retirement, Tontines, Annuities, Selection Effects JEL codes C63, E21, J26