A Mutual Fund to Yield Annuity-Like Benefits

Abstract

The shift away from defined-benefit pension plans is eliminating life annuities received upon retirement. Retiree incomes are becoming increasingly dependent upon retirees’ investment returns and savings consumption rates. The traditional solution, for retirees to purchase annuities, is expensive (because insurance companies must be compensated for bearing systematic investment and actuarial risks) and leaves the investor exposed to the risk of issuer default. The alternative investment vehicle proposed here would allow retirees to diversify life-expectancy risk but retain aggregate investment and actuarial risks. Participants would thus save the cost of the risk premiums for transferring those risks to an insurance company. As a result, the payments to participants from this alternative should be significantly higher than payments from a purchased annuity.

The shift away from defined-benefit (DB) pension plans is eliminating life annuities received upon retirement. As a consequence, both longevity risk and investment risk are being transferred from employers to employees. Thus, retiree incomes are becoming increasingly dependent on retirees’ investment returns and the rate at which they choose to consume their savings.

The traditional way to eliminate these risks is to purchase a life annuity. Annuities diversify retirees’ life-expectancy risks—but at a cost. The insurance company must charge enough to be compensated for bearing the systematic investment and actuarial risks in the annuity contracts. In addition, annuities leave retirees with credit risk—the risk that the insurance company will default.

As an alternative to annuities, I propose an investment vehicle that has features of both mutual funds and tontines (a financial arrangement in which participants share in the arrangement’s advantages until all but one has died or defaulted, at which time the whole goes to that survivor). The vehicle would allow retirees to diversify their individual life-expectancy risk but through a structure that retains the aggregate investment and actuarial risks. By retaining the systematic risks, participants save the risk premiums associated with transferring them to an insurance company. As a result, the payments from the mutual fund/tontine hybrid should be significantly higher than those from a purchased annuity. In addition, a mutual fund–type structure imposes no default risk.

Consider a mutual fund/tontine hybrid that is offered to a single age- and gender-specific cohort (e.g., 65-year-old men). Because the distribution of the participants’ life expectancies and the expected rate of return on assets are known, calculating an annual, fixed annuity payment that can be paid to each participant as long as they survive is straightforward. The tontine-like characteristic arises when participants die; at that time, all claims on assets remaining in the fund are lost. The assets are retained in the fund and used to make payments to surviving participants in the future. Unlike payments from a purchased annuity, however, the fund’s payments are not contractually fixed. Each year, the assumptions are updated and the “annuity” payments recalculated. The payments will vary as a result of differences between realized and expected returns, and between forecasted and realized actuarial experience.

To evaluate the potential benefit of this structure, I compared the monthly payment quoted for a single-premium, immediate life annuity with one calculated for the fund/tontine structure. Purchasing an annuity with a $1 million investment would provide a monthly payment of $6,460 for the 65-year-old retiree. By investing $1 million in the mutual fund/tontine hybrid (using a 4.5 percent interest rate assumption and current U.S. mortality tables), I found the retiree could expect to receive monthly payments of $7,925. That is 123 percent of the purchased annuity.

Tontines could be structured to meet various investment objectives by investing in fixed-income securities, combining bonds with stocks, or adding in Treasury Inflation-Protected Securities to produce an inflation-linked annuity. Also, the assets of more than one cohort could be pooled. That feature makes the tontine an attractive vehicle to annuitize cash-balance pension plans.

The most important parameters required to estimate the “fair” payments are the expected return on assets and the expected mortality distribution. These parameters would not be known with certainty. As a result, when setting the tontine’s payment level, in addition to forecasting investment returns, the tontine’s sponsor would need to forecast longevity drift (changes in the longevity of the general population) and adverse selection (those who choose to participate living longer than the general population).

Although tontines are not legal today, laws can be changed. The coming demographic wave of Baby Boomer retirees, combined with the steady disappearance of DB pension plans, creates a demand for new approaches to help retirees manage their finances. Properly structured tontine-like vehicles can make an important contribution to meeting that objective.

Notes

¹ A tontine is defined by Black’s Law Dictionary as a financial arrangement in which a group of participants shares in the arrangement’s advantages until all but one has died or defaulted, at which time the whole goes to that survivor. The scheme is named after Neapolitan banker Lorenzo de Tonti, who is generally credited with inventing it in France in 1653. Tontines are illegal in the United States. The fear is that they may have the unintended effect of encouraging participants to assure that they become the surviving party by arranging the early demise of other participants. I do not believe the mutual fund/tontine hybrid that I propose creates such a moral hazard. The pools would contain the contributions of thousands of anonymous investors, so a participant is unlikely to perceive a benefit from attempting to eliminate other participants.

² For the remainder of this article, I use the term “annuity” to refer to any annuity purchased from an insurance company and the term “tontine” to refer to an investment vehicle that provides annuity-like cash flows but does not involve insurance contracts or guarantees.

³ Wadsworth, Findlater, and Boardman (2001) discussed annuitized funds, but they proposed them as modifications to annuity contracts sharing investment risks between the annuitants and the insurance companies rather than as self-contained investment vehicles. Davidoff, Brown, and Diamond (2003) discussed “true variable life annuities” but used a mutual fund framework, in which shares would pass to surviving investors, rather than proposing a vehicle structured to provide annuity-like payments.

⁴ If the participants were willing to accept more investment risk in hopes of higher payments, the assets could be invested in an appropriate mix of equity and fixed-income securities. If participants desired an annuity with payments that were constant in real terms, the portfolio could be invested in Treasury Inflation-Protected Securities.

⁵ This rate is similar to the yield on 30-year U.S. T-bonds in February 2006.

⁶ An annuity from the insurance company includes internal forecasts that cannot be observed. They include the expected return on assets, cost, projected mortality distribution, and profit margin. The tontine calculation uses the interest rate on long U.S. T-bonds, and Social Security mortality tables. As a result, an apples-to-apples comparison of the annuity quote from an insurance company and the expected payment from the model-based annuities and tontine is impossible. In the analysis, I assumed that competition among insurance companies keeps them from using unrealistic forecasts to earn higher-than-economic profits at the expense of the annuitants.

⁷ The 8 percent difference between the expected payments from the tontine and the 16-year withdrawal plan arises because the impact of the investment horizon on annuity payments is not linear. For example, the payment from a 16-year plan is almost 5 percent less than the average of the payments from a 12-year and a 20-year plan. In addition, the distribution of life expectancy is highly skewed, which further affects the calculation.

⁸ Some of the changes involve the sharing of investment risk between the insurance company and the beneficiaries. Also, attempts have been made to issue mortality derivatives to allow insurance companies to hedge demographic risks.