26 Jul 2016

Tontines Sound like a Great Retirement Plan

Suppose a bunch of people got together and pooled money to invest in a mutual fund, say. A predetermined amount is withdrawn every year, say 3% of the initial corpus, and distributed among members. When members die, their share of the payout gets redistributed to surviving members, who see an increase in their income.

This is called a tontine, and provides higher returns than any other investment option.

Better than, say, annuities, where you give money to an insurance company who promises you a payment of say 6% of the principal, say, till you die. Annuities give low returns, lower than FDs, because the insurance company has to set aside some of the money to cover risks, like the average longevity being higher than they expected, the market crashing, etc. The insurance company takes these risks when it sells an annuity, so it should put some money aside to cover them. Which reduces returns.

There’s also the risk that the insurance company did their calculations wrong, in which case it can go bankrupt and you may not get your payments. This is not theoretical — the 2008 financial crisis called into question the solvency of a Canadian insurance company and possibly the whole industry.

A tontine, by contrast, doesn’t have that risk at all. There’s no question of insolvency, and no need to set aside any money to cover risk. It’s been estimated that a properly-designed tontine can increase retirees’ monthly income by 10 - 20%.

Instead of an annuity, you could directly invest in mutual funds or other investments. But you could make these same investments via a tontine. And doing so increases the return of the investment, by redistributing dead investors’ return to you.

In fact, one way of looking at a tontine is as a way to increase the returns of any investment. When you invest via a tontine, you’ll get the return of the underlying investment, and more as others die. Not less. So, it’s a way of taking any investment, and increasing its return. How magical is that?

The downside is that your descendants don’t get any money. Of course, there’s no free lunch. If you want higher returns when you’re alive, there has to be a catch. And that catch is that there’s no money left for your descendants. For some retirees, this could be the right answer. Maybe their children are already well off and don’t need more money.

You can, of course, invest some of your money in a tontine and the rest directly in mutual funds or FDs, which your descendants will inherit.

A better solution to the problem of descendants not getting anything is to put all your money in a tontine. If it pays more than expected and more than you need, you can save the extra money in a mutual fund, which your children will eventually inherit.

So, you shouldn’t worry about descendants not getting anything.

The tontine seems like a great retirement option, having high returns and almost no risk. In fact, it takes any investment and magically increases its return. Tontines should become first available and then widespread in India.

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