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There’s a new possibility for funding pension plans, and it uses an old recipe, tontines, but with a twist.
Tontine is a financial product that combines features of an annuity and a lottery. Named after Lorenzo de Tonti, a 17th century Italian banker, Tontine allows people to share investments and divide up the money based on survival—as participants pass away, their share is redistributed to the surviving members. While it might be new to most investors today, it’s an old concept with a long history and was once popular in the U.S.
With many defined benefit pension plans being underfunded, tontine’s time may soon come again. Variations of the tontine principle could be used to create retirement income products that provide lifetime income, generate higher returns, and guarantee pensions that will always be fully funded, sources told Bloomberg Law.
It could also appeal to employers because they would bear no investment or actuarial risks. However, there might be some legal or regulatory hurdles for private-sector employers to launch a tontine type of pension in the U.S., sources said.
Tontine-like arrangements are still used in France, especially when involving inheritance. And TontineTrust, a company based in Gibraltar, is building a tontine product using blockchain and smart contract technologies to eliminate fraud and maximize payouts.
Tontine originated in Europe in the 1600s as a strategy for government financing. It emerged as a popular investment in the U.S. after the Civil War but fell out of favor because of instances of fraud. Investigations of the insurance industry in New York led to legislation in 1906 that banned tontines in the Empire State, according to Jonathan Barry Forman, a professor at Oklahoma University School of Law, who frequently writes about pension issues.
In a simple tontine, members contribute equally to buy a portfolio of investments that is awarded entirely to the last surviving member. Alternatively, the system could be designed to divide the balance of a member who dies between surviving members and could even approximate actuarially fair annuities where payment reflects member’s probability of death, Forman told Bloomberg Law.
The idea of survivors getting the money of someone who died is nothing new, Lane Ginsberg, a registered investment adviser who is the founder and owner of Freedom Retirement Advisors, told Bloomberg Law.
In annuities, insurance companies make guarantees of payment to participants, knowing that based on mortality studies, every year a percentage of recipients will die. When an annuitant dies, everyone else alive gets “mortality credit"—they share his money because it’s with the insurance company. But in a tontine, they share his money because it stays in the pool, Ginsberg said.
Because the money stays in the pool, a tontine will always be fully funded. And because a tontine doesn’t promise the exact amount of money paid out, the party offering it has no investment or actuarial risk. These are the two main advantages of a tontine compared to defined benefit plans, and it could actually replace defined benefit plans, Forman said.
Now, especially, is a good time to consider bringing tontines back as more and more defined benefit plans are underfunded, Ginsberg told Bloomberg Law. The underfunded single-employer plans insured by the Pension Benefit Guaranty Corporation had a total underfunding of $339 billion and $495 billion for underfunded multiemployer plans, according to the PBGC’s 2015 pension data tables.
Not only are risks much lower for employers in tontines, the returns could be higher than traditional investments. “It’s kinda like an insurance annuity but you don’t have the profits, the cost of operations, the commissions and the sales costs that insurance companies have,” Ginsberg said. “Theoretically they ought to be able to get more money at a lower cost.”
It almost sounds too good to be true. So, are tontines legal? Is that 1906 ban still effective?
To be sure, the 1906 legislation didn’t specifically ban the sale of tontines, but made it hard to defer payments for one year, Forman said. Only two states—Louisiana and South Carolina—ban them.
If employers were to consider using tontines, it might take some legal efforts to get regulatory approval.
“You would want a ruling from the IRS on the tax consequences of products you designed. You would get approval from a state insurance agency, or a big strong legal opinion saying that you didn’t need that,” Forman said.
The IRS told Bloomberg Law that the agency “only provides guidance on actual situation and transactions, not proposed or hypothetical ones.” And a DOL spokesperson said “At this time EBSA has no pending requests for guidance.”
There’s some precedent for offering a tontine as a retirement product. TIAA has been offering variable annuities since 1953; and these pooled annuities, which are very similar to tontines, are authorized in New York and many other states, Forman said.
However, the Employee Retirement Income Security Act might present some hurdles for private-sector employers that want to launch tontine pensions as a tax-qualified plan, Forman said.
For example, tax code Section 401(a)(8), which applies to defined benefit plans, indicates that “forfeitures must not be applied to increase the benefits any employee would otherwise receive under the plan.”
“A defined benefit plan would normally say, for example, when you retire you get 2 percent times years of service times your final average pay, so you get a pension 60 percent of your final average pay; but it can’t say ‘Oh, but if a lot of people die you will get more,’” Forman said. What you can do, however, is just give them more, because given this workforce, you assume some will die before retirement, he said.
State and local governments will start doing tontine pension “first because they’re not subject to ERISA. State and local governments can pass a law saying this is how we’re going to create a pension for you from now on,” Forman said.
Gary S. Mettler, who frequently writes about annuities, agrees that employer tontines might start in state or local plans, or non-qualified plans. “There’s nothing preventing employers from entering into a non-qualified plan arrangement. The tax benefits just wouldn’t be as great,” said Mettler, who also had experience in defined benefit plans as a litigation consultant.
However, Mettler doesn’t see a large-scale comeback for tontines any time soon. “It’s going to take a lot of time. It needs to be successful at the individual level first before expanding to the public pension level. Certainly there’s room for that,” he said.
New technologies are another factor for reintroducing tontines now, said Dean McClelland, CEO of TontineTrust, which is tapping blockchain technology to revive the old tool.
“The reason why the immensely popular and successful tontines were withdrawn from sale at the beginning of the last century was that the insurance companies issuing them had irreparably lost the trust of the consumers as well as the regulators”, McClelland said, “To relaunch this product requires a whole new level of trust to be established between the members, the issuers and the regulators. That is what blockchain enables.”
A blockchain is a continuous ledger that keeps a permanent record of all transactions made in chronological order. It’s considered a secure way of storing data because previous records can’t be altered unless a majority of the network approves. Although some people are skeptical about cryptocurrency, the blockchain technology itself has been tapped by many industries and governments, including the U.S. federal and state governments.
A problem blockchain could solve for tontines is fraud, McClelland said. Tontines in the past couldn’t properly recognize the actual person in the pool. Incidents happened in which investors chose a child as their tontine nominee, and if the child died, they would pick another child and pretend that child was the original nominee. But blockchain could help build a product that would analyze a multitude of biometrics as participants enroll and could continuously identify the person going forward, McClelland said.
In addition, blockchain could bring much more security and transparency because it could provide an immutable, public log of all contributions, fees, distributions, locations, and composition of assets, McClelland said. With these data publicly exposed, regulators, analysts, and the general public could audit the product’s past and projected returns, he said.
“Such transparency is the only true guarantee that there is no double counting of assets, no hidden liabilities and that the Tontine, or indeed any financial product, is fully funded for all of the expected payouts,” TontineTrust’s whitepaper says.
Smart contract is also being leveraged to develop a “smart actuary” that allows the tontine to function on a sort of autopilot based on set rules, McClelland said. “Smart contract” is a feature of some blockchains that allows coded contracts to execute themselves when predefined conditions are met. Retirement plan and insurance industries and beyond have been trying to tap this feature.
If successfully built, the smart actuary system, with rules coded into smart contracts, would manage monthly payouts based on the value of the underlying asset, the returns, the life expectancy, and mortality of members, McClelland said.
How should government regulate such contracts and transactions? Well, the Gibraltar government has introduced a regulatory framework for blockchain businesses that would be effective on Jan. 1, 2018. The legislation addresses issuing license to blockchain service providers and requires them to abide by a series of regulatory principles, including protecting customer assets. In the U.S., Arizona has recognized the legitimacy of signatures and smart contracts secured on blockchain in a bill approved in late March.
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