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I don't see how this is really different from an annuity beyond getting a bonus payment when someone dies and not being funded in a way that you're sure the mon
I don't see how this is really different from an annuity beyond getting a bonus payment when someone dies and not being funded in a way that you're sure the money won't run out prematurely.
With an annuity, a company sells you a plan that will pay you $X/mo for a lump sum of $Y. Those that die below actuarial estimates end up paying in more than they get out while those that continue living get the profits from it.
I guess the difference is that with an annuity, you're expecting the monthly payments to be pretty close to what you're paying in over a normal life expectancy. So, a million dollar annuity with a 10-year life expectancy might net you $8,000-$8,500/mo. By contrast, a tontine would see you put in a million dollars and then maybe get $3,000 per month with a 10-year life expectancy with those that outlive others getting more money as time goes on. So, if you live long and others die, your payment might go up to $10,000 or $15,000. Is that the point of the tontine?
But why on earth would that be the future of retirement? An annuity is predictable. The risk is borne by the company selling it. With a tontine, you get unlucky and everyone lives long and you're in a bad situation. In the best case, your payments go up, but why would you want the chance at $10-15k after others have died rather than $8k predictably always?
An annuity already spreads the risk and uncertainty of life expectancy. That's the problem we're trying to solve. An annuity already lets you profit off those who die early who have paid in more than they take out - and if you live long you get more than you paid in. If you want to add the morbidity of the tontine to your retirement plan, take out life insurance policies on your friends and cash in when they die young and lose money if they live a long life. Combined with an annuity and you basically have the tontine. You get regular payouts from the annuity and you profit when your friends die via life insurance policies on them.
But looking at that, why bother with the life insurance policy? Why wouldn't you just get the annuity and have a predictable, steady income?
* You might not like companies that sell annuities and think they aren't a good investment. However, they're sound compared to some hacked-together, crowd-sourced thing that isn't backed by someone reliable with deep pockets. I won't personally buy an annuity, but they're based off spreading the risk in a conservative enough way to guarantee predictable funds (along with a reasonable profit for the company). An under-funded tontine that has people live longer than expected would simply run out of money and leave people destitute.
The thing that I feel is relevant is: "The risk is borne by the company selling it." That risk means that they have to give you a very bad rate to cover their risk and still make a profit.
With a Tontine the risk in the return is borne by the individual who can therefore share in the upside as well as the downside.
I thought much the same thing. The price and returns of the annuity assumes that some people will die before life expectancy, and others will die later. I don't see what's unethical about that.
There are 3 big problems with pensions. Firstly, people contribute too late, so they don't get the benefits of 50 years of compound interest and stockmarket booms. Second, many companies mismanage them - see the current Philip Green at BHS debacle in the UK for an example. Thirdly, too many people don't contribute anything at all (for whatever reason), but still need some kind of income in their old age.
I don't see how tontines get round any of these problems.
This is completely correct. The only reason these sorts of silly financial instruments are available, and the only reason you're not at the top of the thread, is because the level of basic economic literacy is so low.
The question of why annuities are relatively unpopular is an interesting social/institutional one. From talking to some financial planners, it sounds like some crooked origins gave them a bad reputation (like used cars) that they have struggled to shake. Even today there are an unusual number of scummy annuities, although it's much lower than in the past. I suspect it's because they have several moving parts, and are a bit harder for the financial unsavvy to value and compare between companies, so the market gets more swindlers.
EDIT: I previously also wrote "and the only reason this article is in the Washington Post without directly addressing these points," which is incorrect, as
roymurdock helpfully pointed out.
The article touches on this somewhat, but I think said differently:
In an annuity, you're gambling against your own death.
In a tontine, you're gambling against the deaths of others.
From a purely cultural perspective, I think most Americans would rather gamble against the deaths of others.
The article addresses both your point and the GP's point directly:
Economists have long said that the rational thing to do is to buy an annuity. At retirement age, you could pay an insurance company $100,000 in return for some $5,000-6,000 a year in guaranteed payments until you die. But most people don’t do that. For decades, economists have been trying to figure out why.
James Poterba, an economics professor at MIT who has extensively studied American retirement, says it’s still a mystery why annuities are so unpopular. A number of theories have been advanced — people might like to leave some money for their children, or they might worry about medical expenses late in life. Poterba and his colleagues have also pointed out that Social Security is already like an annuity, promising constant payments for life.
But there’s also some evidence that people just irrationally dislike annuities. As behavioral economist Richard Thaler wrote in the New York Times: “Rather than viewing an annuity as providing insurance in the event that one lives past 85 or 90, most people seem to consider buying an annuity as a gamble, in which one has to live a certain number of years just to break even.”
Here is where tontines come in. If people irrationally fear annuities because they seem like a gamble on one's own life, history suggests that they irrationally loved tontines because they see tontines as a gamble on other people's lives.
I agree that financial literacy in the US is low, and the basic accounting/finance classes should be required at the high school level, but this article is good and draws upon a decent amount of actual economic literature. I recommend reading it to the end.
I actually did read this article to the end back when it was written last year, but I wrote the above comment based on a faulty memory. Thank you for the correction. The problem with the article is less than I claimed, but it is still written in a confusing and sensational way.
I'd bet it's mostly to do with fear of sudden, large expenses. Part of the reason to save up a large stock of funds is to be able to pay off big, unexpected bills. To shell out a large sum for an annuity also requires them to shell out (some?) of that ability. The elderly probably couple that with a disdain for taking on financial debt.
I'd like to put forward another possible reason why someone might opt to not get an annuity...
If you are financially savvy, or can pay someone else to be, does it not make more sense to invest your money yourself? There are a number of "too big to fail" companies, like GM, and Wells Fargo, that offer dividends. If you composed a portfolio of high dividend, stable, stocks... Could you theoretically have a "guaranteed" monthly income AND the ability to liquidate, in the event of an emergency?
> If you composed a portfolio of high dividend, stable, stocks... Could you theoretically have a "guaranteed" monthly income AND the ability to liquidate, in the event of an emergency?
No. You can buy an annuity, or US Treasury bonds, but guaranteed high returns don't exist, and adding in a liquidity requirement doesn't help.
Note that GM declared bankruptcy in 2009. Even if it is still "too big to fail," that doesn't mean investors can't lose all their money.
I never claimed guaranteed high returns. An annuity doesn't guarantee you "high" monthly income. It guarantees you AN monthly income.
My comment was to address the question regarding why more people don't use annuities, and I'm not sure your response counters that.
Regarding GM, yes, I'm aware they went bankrupt. But correct me if I'm wrong - Investors didn't lose their shares? The government bailed them out, and they're operational today. That's what I mean by "too big to fail".
The unpopularity of annuities seems like a direct consequence of loss aversion, which says losses are more psychologically powerful than equivalent gains. [1]
If I trade $100k in savings for an annuity, I'm starting off at a deep "loss", which becomes a "gain" only at some point in the uncertain future. Not surprising that most people won't take that bet.
[1] https://en.wikipedia.org/wiki/Loss_aversion https://en.wikipedia.org/wiki/Loss_aversion
Having worked both in Finance on Wall Street - for an ethical shop with quality employees in a modest market (Munis) - and in Insurance/Risk Management, I can off-hand say that I think the actuaries and quants in Insurance are easily comparable in talents and abilities with Finance peers. Thus, I think some 'structured products' from the Insurance industry - rather than Finance as most people might think of it - are worth consideration. Sure, both avenues are regulated, but scams will show up in any industry. What I'm getting at is Insruance isn't supposed to be "flashy" - the numbers are supposed to work.
As an aside, I do see the two trying out new, potentially risky synthetics called Insurance Linked Securities. Not sure it has been much of a market in the past - existed, sure, but there's a lot of sloshing Central Bank injected money looking for returns...and pension funds...and, well, everybody. Eek!
A few potential reasons they're interesting compared to annuities: they're more honest about the risk, the risk is easier to understand, the risk is incremental rather than binary, and the lottery aspect might encourage better saving behavior/make them more marketable than annuities.
Annuities are typically sold as "risk free", but you have the risk of the insurance company becoming insolvent. A tontine's risk of everyone living longer is obvious. Since annuities have general credit exposure to the insurance company, to understand the credit risk you need to understand all of the insurers lines of business. A tontine with segregated assets doesn't depend on the other business of the manager for solvency. Some of these issues with annuities can/are mitigated by regulation, but that's another thing you have to understand in order to understand the risk. Customers understanding the risk should lead to better decisions about how much to rely on it.
Because annuities have guaranteed payments, if life expectancy increased the insurance company would continue paying out an an unsustainable rate, and when it ran out of money benefits would go from 100% to 0%. A tontine would instead reduce payments incrementally so that it's always sustainable.
Finally, people don't always make financial decisions in the way economic theory suggests they ought to. In particular, people buy way more lottery tickets than economists think they should, and way fewer annuities. If you sprinkle a little bit of lottery into an annuity it might become more marketable, leading to better average financial decision making.
Perhaps the guaranteed payments of an annuity exceed the guaranteed returns of an investment portfolio. The companies managing the annuities have the capital to invest in businesses and ventures that a typical person can't. Such as financing, large real estate developments, or investments in startups, small businesses, or private equity.
With a stock portfolio, the only guarantee cash-flow is dividends since capital appreciation varies a lot year-to-year. Dividends are usually in the 2-3% range. A large, diversified real-estate portfolio might see 8-15% yearly returns in cash, which can be distributed, saved, or reinvested as needed.
No, that doesn't insure against old age. Consider this method of getting a guaranteed income: take your pot of money M and divide it by N, where N is the maximum number of years you could expect to live (if, say, you lived to 121). Then you can get a guaranteed income of M/N per year. But this is silly, because most of the time you die much earlier, and the money goes to waste.
The whole point is to transfer money from worlds where you die early to worlds where you die late. An annuity does this by pooling your money with many people living to different ages. For a large pool and accurate actuarial tables, the number of people who die every year can be predicted, so one can determine an amount of money to pay out each year such that each surviving person gets the same amount each year, with long-surviving people getting more total money (as desired).
I meant to reply earlier, but <something, something, work>. Anyways, now that I'm off:
jessriedel found an annuity with a good return. But I also have another point to make:
Annuities mitigate risk. This is the same reason people invest in various government bonds (directly or wrapped up in other investment packages). You're getting a guaranteed return on an annuity. Your rent (and the underlying property) are not guaranteed. The risk in them offers greater opportunity for profit, yes. So why not do both? If you have the money, you ought to consider both (if you can find a good annuity or similar investment).
If you don't have enough money, your choice will come down to your risk tolerance. I'm 33. I'm physically fit, rarely ill, with no debt, a college degree, a stable job, and even if it weren't stable I'm a more than competent programmer and mathematician so I can find work somewhere. I can invest in riskier things than, say, my 60 year-old parents with the almost paid off house, who would have to move (emotionally challenging at their age) to find gainful employment (also difficult at their age) should they lose their money in a bad investment. For them (also note: annuities are targeted at this age group due to the way the sellers of them make profit off of them), an annuity with a decent return is better than purchasing and renting out a place if they have to choose one.
If they have the resources, they don't have to choose. If you're young, take the high-risk investments, as you age move your earnings to safer, stabler, lower earning investments, and retire with confidence.