A Case for the Gold Tontine
/When a person is healthy and productive it makes economic sense for them to convert a portion of their income to wealth, so that they can then exchange that wealth to income when they are aged and can no longer work.
If a person wishes to not be reliant upon others for their basic needs, the amount of wealth they accumulate while healthy and productive should be sufficient to last until they die.
People in good health and with skills in demand have a choice as to when they wish to no longer be in receipt of an income from productive activities – often described as ‘retirement’. Three common factors influencing the decision about when a person retires are: perceptions of ‘financial security’, ‘personal health & physical abilities’, and ‘reaching eligibility age for an age / service pension’.
A typical age when a person retires is around 60-63 years of age. It is at the higher end of the range for males and the lower end of the range for females. That said, retirement ages reflect personal circumstances and are widely spread. This can be seen from the survey results of Australian retirees which showed 17% of survey participants recently retired aged under 55; 19% between ages 55 and 59; 30% between ages 60 and 64; 22% between ages 65 and 69; and 12% aged 70 or over.
In that survey, the average age at retirement from the labour force (for those still alive and aged 45+) was relatively consistent for each grouping of ‘total gross weekly household income from all sources’ suggesting that ‘financial security’ is quite a subjective assessment as a factor influencing the timing of a person’s retirement.
It is possible that those retiring at early ages such as ‘labourers’ [average retirement age of 55.9] also started earning income at an early age, and those retiring at older ages such as ‘professionals’ [average retirement age of 60.3] started earning income at later ages after longer periods of tertiary education. This may result in similar average working lives of around 35-40 years for both groupings. Individual working lives will vary widely as seen by the large spread in retirement ages. Other factors, such as health and time spent raising children at home, will also influence the length of a person’s working life, probably with a downward bias.
A person needs to accumulate sufficient wealth within their working life so that they can then convert that wealth to income throughout the duration of their retirement. This may be a modest task when the duration of retirement is short, but it is a significant task when the duration of retirement is long.
The improvements in mortality over recent decades have increased the life expectancy of the population. There is now a large gap between the average age of retirement, of say age 62, and an age to which it is quite possible a person might live, to say age 87. This requires a person to successfully convert sufficient income to wealth during at best a 35-40 year working life that must last for an expected 25-year retirement period. This is a difficult task as it means a person’s savings rate must be quite high. In addition, the quality of any accumulated wealth must be maintained throughout the retirement period.
The high ratio of retirement years to working years (say 25:38) when combined with an ageing of the population implies that the current level of accumulated capital base of the economy should be at a high level. It is questionable if that is the case. Instead, retirees commonly appear to be excessively reliant upon the State for their future income. The State, however, hasn’t the wealth required to back it pension liabilities. In all likelihood retirees on average will be faced with either returning to productive activity and/or sharply declining living standards.
Even if a person were to accumulate sufficient wealth to maintain themselves until age 87 with further improvements in mortality rates it is becoming increasingly likely that person could live past that age and live well into their 90s.
It is very difficult for a person to accumulate sufficient wealth to be self-sufficient in the situation when they retire around ages 60-63 and then live to more than 87 years of age. For example, if a person were to live to 100 years of age after retiring at age 62, the ratio of retirement to working years would increase from 25:38 (71%) to 38:38 (100%). Without government ‘welfare’ support this would be debilitating to most people and a large strain on family & friends. Of course any true government ‘welfare’ support would require taxing the income of (younger) others which would only result in lower accumulated wealth in retirement for those people. As such, we need a commonality based solution to this problem, and it can be eloquently provided by the ‘tontine’.
The tontine is a form of insurance.
Much of what today is described as insurance, such as ‘mortgage protection insurance’ or ‘lifetime annuities’, is a misnomer. Instead it is a directional gamble made by an insurance company which is often only exposed on the occurrence of the insured event - as we saw with AIG on its credit default swap obligations.
A proper definition of insurance is a form of cover that provides indemnity for a mutualisable risk event over time and space. A tontine fits this definition of insurance.
The tontine is essentially a reverse life insurance arrangement within a mutualised pool. If a person dies, their contributed capital is distributed amongst the other living people in the pool as a ‘survival credit’. The calculation of the survival credits paid to each living person in a period is based on that person’s contributed capital and their deemed mortality rate for that period. Those with more capital and higher deemed mortality rates receive a greater proportion of the ‘survival credit’ distribution. The payment of ‘survival credits’ reflects the actual mortality rate of people in the pool, allowing the concept to be a mutualisable risk event. If the pool is of sufficient size to remove much of the idiosyncratic death risk of the cohort, the tontine participant, if still alive, should receive distributions from the tontine at a rate similar to that of their deemed mortality rate (qi) divided by their probability of surviving the period (1-qi).
The deemed mortality rate (qi) is based on a best estimate of the mortality rate for an individual using set criteria (i.e. annuitant selection, age, sex, select period), and is only used to equitably distribute the ‘survival credits’. This approach for the allocation of ‘survival credits’ allows the tontine to be ‘open-ended’. This way the tontine does not need to experience a decline in the number of participants over time.
It should be noted that the tontine only provides insurance coverage for the idiosyncratic risk of living, and it does not provide insurance coverage for the systemic risk of improving / deteriorating mortality of the cohort within the pool. Under our definition of insurance, the systemic risk is not an insurable event, as it is not a mutualisable risk. Insurers providing this type of cover are prone to failure.
A participant in the tontine would not put all of their wealth into the tontine. The proportion of wealth put into the tontine would depend on a participant’s personal circumstances, including their level of wealth and current health status.
It is not possible to offer a ‘withdrawal benefit’ under a true tontine as the contributed capital cannot be withdrawn if a person suspects they might die in the near future. That would be unfair on the other participants in the pool who are putting capital at risk.
If a person survives the period within the tontine, they would expect a ‘survival credit’ equal to the capital put at risk multiplied by qi/(1-qi), plus their share of the investment return on the assets held by the tontine, less any expenses and charges.
Typically, only a healthy life would join a tontine. This is due to the factors used to determine a person’s deemed mortality rate used in the actuarial allocation of the ‘survival credits’. If only basic factors such as age, sex and select period are used, it makes economic sense for participants to only join if they consider themselves to have close to or better than average life expectancy than the rest of the pool. That said, it may be possible to broaden the factors used to determine the deemed mortality rate or alternatively to offer a ‘bad lives’ tontine which would be restricted to those with poor records of health.
The reason why the tontine can provide an elegant solution to those who live to an old age is that expected mortality rates typically rise sharply from ages 85-90 onwards and therefore provide a good reverse life insurance ‘premium’. Up until age 70-75, expected mortality rates tend to be quite low, so the ‘premium’ received from the reverse life insurance is too modest for most to place any capital at risk.
If you were to live into your 90s, the timeframe for participating in a tontine is around 20 to 30 years. As mortality rates rise with age, if you were to live to 100, around 2/3rds of the payment from the tontine would be received from age 90 onwards. The capital put at risk in the tontine must be invested in suitable wealth that will still be able to provide income over this period. As the tontine is likely to be a major source of a person’s income during the age period of 90-100 years, the quality of the assets backing the tontine must be high.
The highest quality of wealth is the gold coin, closely followed real (gold) bills of exchange. Given the duration of the product and the requirement for high quality wealth, there is an argument for an asset allocation of a tontine to gold coin and real (gold) bills of exchange.
Depending on the marginal investment return from ‘gold mortgages’ and ‘gold equities’, there is also a case for also including those assets in the tontine.
Sadly, at the moment, there is no available market for real (gold) bills of exchange or for gold mortgages. There are, however, some high quality exchange traded companies that could be classified as ‘gold equities’. These should not be confused with gold mining companies. As such, if offered today, the tontine would need to be backed by gold coin and ‘gold equities’. The asset mix of gold coin and ‘gold equities’ could be managed in a form of arbitrage by the tontine provider.
In summary, the gold tontine helps provides an elegant solution for the insurable risk of running out of wealth (exchangeable into income) if a person lives much longer than others in a similar cohort.
As first published in Course of the Exchange, Fekete Research, 1Q16
References:
Monetary Economics 102 Lecture 2: The Exchange of Income and Wealth, Professor A. Fekete, 2003, http://www.professorfekete.com/articles/AEFMonEcon102Lecture2.pdf
New thinking on how to solve Australia’s post-retirement challenge, Paul Newfield, Actuaries Institute Financial Service Forum 2014 http://www.actuaries.asn.au/Library/Events/FSF/2014/NewfieldPostRetirementPaper140505.pdf (Note that Newfield uses a different formula for the allocation of ‘survival credits’ than proposed here).
Retirement and Retirement Intentions survey July 2012 to June 2013, 6238.0, Australian Bureau of Statistics, 2013