A hard problem in retirement planning is a safe spending rate, so you don’t outlive your money. One side of the problem is, how much can you spend and not risk running out of funds in say, a 25-year retirement? See, for instance, our Cat Food Calculator mad science experiment. One can even calculate a spending solution which maximizes your certainty-equivalent spending based on historical returns, and your risk tolerance.
The other side of the problem is, what happens if you live to 105 and have to fund a 40-year retirement? If you plan for 40 years, you are likely to under-spend and leave a large estate. If you plan a 30-year retirement at 65, and it gets you safely to 95, there is still a small but potentially catastrophic possibility of outliving your savings.
A tontine can address this problem. Here’s how it might work:
- Imagine a Kickstarter-like page: “Seeking 1,000 men (or women) who were 50 years old on Jan 1, 2015 to start a tontine.” When we get 1,000 eligible participants commit, we launch the tontine.
- Each participant funds the purchase of 200 SPY ETFs — at current prices about $40,000. (The math works out if you let people vary their contribution, within limits, but lets keep it simple).
- The ETFs go into a trust.
- When the cohort reaches age 801, about 53% of males will still be alive. At that point the tontine begins paying out.
- We set up a fixed annual distribution of shares to each survivor. The amount is set at, say, 10% of the shares divided by the surviving participants.
- Let’s hope we get a 4% real return on the SPY, and assume1 that we can re-invest dividends tax-free. After 40 years your initial $1 investment in a SPY has grown to about $4.80.
- In addition your equity share in the trust has almost doubled because 48% of the original participants are no longer with us. Your $50,000 initial investment has bought you a $366,000 old-age fund.
- So 10% of the SPYs are distributed. Their value has gone up ~5x. The survivors are about 50% at this point. So you can get a distribution valued at $36,600 in year 1. The trust can afford to distribute the same number of shares to each survivor every year, and never run out of money assuming the current life table. With luck, the S&P continues to appreciate. Your initial $40,000 has bought about that much per year for the rest of your life.
- If the tontine runs out of money because cancer has been cured and everyone is living to 120, that’s it, it’s out of money. It’s a risk you take, along with S&P fluctuations. As your retirement progresses, you will want to monitor the expected payout from the tontine, plan and adjust accordingly.
- When there are say 10 people surviving, the remaining SPYs are distributed pro-rata. Saves on administrative costs and gives the lucky ones a payoff and an estate.
What is insurance except a pool of people coming together to share risks? What better product for our era than a crowd-sourced, peer-to-peer, sharing economy life insurance solution.
The great thing about this tontine is, for a small investment you fund a big part of your needs in the event you are one of the lucky ones to live a really long time. You can focus on saving funds for the earlier part of retirement when you know you are likely to be alive. You can plan to spend pretty much your entire nest egg over the first decades and don’t need to worry about the tail risk of living to 105.
There is an existing product which also addresses this problem: an insurance company variable annuity.
The problem with the variable annuity is, it can be quite expensive — it is a market that is a bit of a minefield. Variable annuities are complicated, and are often high commission products. They often have high expense ratios. (Vanguard is a great provider, but if I read it correctly, they charge 0.46% to 0.77% per year on top of the management fees for the funds you invest in. Adds up over 40 years.) The insurance company takes the other side of the longevity risk, ie they keep whatever is left over when people die quicker than expected. There is a small, but potentially non-negligible credit risk. If an insurance company goes broke because, for instance, its overall returns are too low and it takes too much of the wrong kinds of risk, you might not get the expected payoff.
At scale, the tontine should be feasible at index-fund expense levels, like 25bp. Or, possibly, more like account maintenance fee levels. The problem with the tontine is… it’s illegal in the USA.
But it really would be a great product. It’s extremely unfortunate that our system allows all sorts of expensive, gimmicky products, not to mention outright shenanigans, but blocks relatively simple, legitimate, useful peer-to-peer products.
I encourage any renegade entrepreneur to take a crack at it, set up a Kickstarter-like website, and dare the authorities to shut it down. Uber didn’t ask permission. It takes boldness to disrupt financial services. But regulators may not be sensitive to the public interest, and insurance companies may not be as easily overcome as taxi commissions and fleet operators.
Like Warren Buffett on space exploration and tech stocks, I applaud the endeavour but may prefer to skip the ride.
(Disclaimer: it would be immoral to take Uber-like risks with people’s retirement savings. Perhaps it’s time for a group of willing participants to try a test case and challenge the law. Or maybe some very smart lawyers can identify a workaround. Or maybe there’s a Bitcoin-like solution. That’s a joke, mostly: you can’t keep a large pool of real-world assets like SPYs outside the law.)
1 The tontine could, of course, invest in something besides the S&P, like a bond fund, a balanced portfolio, etc. It might also make sense to let investors fund the tontine over say, 5 or 10 years. It could also start paying before age 80, for instance it could fund an entire retirement plan starting at age 65. I chose this example because it highlights how the tontine simply, effectively, and cheaply mitigates longevity risk.
2 Unfortunately, an unwarranted assumption: In a taxable account, dividends would be taxable. In an IRA, minimum distributions would be tricky, one might have to start distributing at 70 ½.