Government employees need lifelong incomes to stay independent and promote public interest. Private employees serve no higher cause.
Replacing public pensions with traditional defined contribution (DC) schemes like Voluntary Pension System (VPS) and provident funds (PFs) will destroy the security of lifelong incomes. Government employees will be forced to take greater interest in personal finance. New forms of malfeasance will emerge that will be hard to catch and difficult to reverse.
A better alternative would be to offer a superannuation fund with tontine features. A tontine fund pays lifelong income but does not allow any withdrawals. In this sense, it is quite similar to defined benefit (DB) plans and insurance annuities.
There are market and behavioral aspects that support tontines over other income solutions
The major difference is that a tontine fund transfers investment and group longevity risk from corporate sponsors and insurance companies to its participants. Sponsors do not guarantee payments and do not carry funding liability.
Advantages of public pensions
The existing government pension system has three advantages.
First, lifelong pension allows government officers to stay independent and not curry favor with future employers. Uncertainty of retirement income would corrode independence and introduce a natural conflict between personal and public interests.
Second, the existing system does not allow conversion of accumulated benefits into discretionary cash. On the other hand, savings in VPS and PFs can be easily withdrawn and invested in legally disguised foul deals that guarantee high profits.
Third, pensions for life actually lower overall employment costs. Retirees prefer lower savings, and as a corollary accept lower salary, if retirement nest-egg comes in the form of a guaranteed life pension rather than as lump sum cash with uncertain income.
In pursuing the reform of public pensions, we should not throw the baby with the bathwater. Income security is sacrosanct and inviolable for good governance.
Tontine history and modernisation
Tontines were first proposed in 1641 in Portugal. Earlier versions provided asymmetric profits to investors who lived longer. Their purpose was to lower the cost of sovereign debt by appealing to people’s speculative instincts.
Dutch cities set the ball rolling in the 1670s. England’s first long-term sovereign debt — for 99 years — was raised through a tontine in 1693. Many other European countries followed suit over the next two centuries. Almost half the US households held saving products loosely called tontines during the 1890s.
Tontines disappeared from the scene around 1905 when an outright fraud of US financial companies under the tontine banner triggered a political backlash and regulatory intervention.
The worsening retirement crisis of the 21st century has resurrected tontines among pension scholars. Old tontines have been modernised to eliminate lopsided payoffs to survivors, deliver levelised payments similar to DB plans and annuities and untangle lifetime income from sponsors’ liability.
Sweden’s national pension system explicitly incorporates tontine principles. TIAA in the United States has been offering tontine-style products since 1952. Some public pension plans in Wisconsin follow tontine principles. Similar income solutions are available in Japan, Israel and South Africa. Tontines are permitted in the European Union and the United Kingdom.
Working and comparison
The workings of a tontine are transparent, rule-based and actuarially fair.
During employment, the government will make a monthly contribution on behalf of each person. It will have no other obligation. The employees’ benefit in the superannuation fund will grow from three sources — monthly contributions, investment returns and mortality credits.
Mortality credits are residual balances of decedents that are transferred to survivors in a tontine instead of heirs. They are integral to all income products, enhance gross returns and work behind the curtain in funded state pensions, corporate DB plans and insurance annuities. They are a key pillar of an egalitarian society. They are officially called ‘inheritance gains’ in Sweden.
After retirement, monthly contributions from the government will cease and pay-outs of tontine pension to retirees will begin. The accumulated benefit of retirees will continue to grow from mortality credits and absorb investment gains and losses.
A tontine structure has enough flexibility. It can incorporate a limited bequest motive. Income payments can continue to benefit the surviving spouse and extend to children below a certain age. It can be made Shariah-compliant.
There is one drawback against other lifetime income solutions. Retirees’ tontine income will fluctuate due to investment volatility and unexpected increases in group longevity.
The compensating advantage is that a typical retiree’s tontine income over a lifetime will be higher than a DB plan or an annuity. The reason is simple. A tontine transfers full benefit of investment gains and mortality credits to beneficiaries. No deductions need to be made to defray the cost of payment guarantees.
Data in the United States shows that tontine pay-outs should be 11-17 per cent higher than an annuity.
There are market and behavioural aspects that support tontines over other income solutions. Employers in the public and private sectors no longer want to offer DB plans. Annuities remain unpopular in the West despite clear advantages over a self-managed retirement portfolio. They are not available in Pakistan and likely to fare much worse.
Tontines have three overwhelming advantages over VPS and PFs. One, retirees need not worry about how long they will live and whether they will have lifelong income. Two, mortality credits enhance returns of surviving participants. Three, retirees’ income fluctuation is lower.
They have a fourth advantage over VPS. A tontine superannuation fund captures all the strengths of a pooled employer fund — avoidance of behavioural pitfalls, lower cost, access to the best investment expertise and superior ‘skin in the game’ oversight.
Lifetime tontine income will be higher and smoother than what is possible under VPS and PFs.
The traditional DC schemes are designed for asset accumulation and not for lifelong income. Private-sector employers accept and manage their weaknesses as a trade-off against expensive pension guarantees. Their choice does not pose a moral hazard to society.
The cultural setting of government offices is different. Moral hazard to public governance is significant. A shift to traditional DC schemes will bring capital market stress and provide easy access to cash. It will induce self-dealing behaviour in government officers and compromise public interest.
There are other big social issues at stake. Recurring income dignifies old age, saves elderly from financial abuse and motivates their caretakers in many cases.
An employer’s pension honours loyalty and good performance. A lump sum settlement abandons these virtues to cold fate.
The government should facilitate income solutions for the private sector rather than regress and thrust malaise of traditional DC schemes on its workforce.
A tontine superannuation fund offers a better solution through lifelong income and higher expected pay-outs. It strengthens the case for public pension reform.
The writer is the CEO of Magnus Investment Advisors. Views are his own
Published in Dawn, The Business and Finance Weekly, January 18th, 2021