Consider a retirement plan with the following characteristics:
• The plan provides an adequate stream of lifetime payments to plan participants
• Plan sponsors have a fixed contribution to the plan (just like a defined contribution plan)
• Plan sponsors have no investment, longevity, or other actuarial risks
• The plan is always fully funded
Sounds too good to be true doesn’t it? It turns out that the tontine pension plan has all of these characteristics. This paper by Jonathan Barry Forman and Michael J. Sabin discusses the inner workings of such a plan and how the above four characteristics come to fruition. The paper goes on to suggest that the tontine pension plan can solve the public sector pension underfunding crisis.
Never heard of a tontine? Then you are not alone. Simply put, a tontine is a financial arrangement where each member (usually the same age) contributes an equal amount. The total is awarded entirely to the sole survivor. Tontines were actually quite popular prior to the 19th century. In the early 1900s, however, the state of New York passed legislation that all but outlawed tontines, and other states followed.
While the paper doesn’t suggest that we lobby to resurrect pure tontines as financial instruments, it does suggest that we use the tontine concept to create a type of pension plan—the tontine pension plan.
The concept is simple. An employer contributes a fixed amount per year to an employee’s account; this account, managed by the employer, accumulates to a fund which, upon retirement, is converted to an annuity benefit payable to the employee. When the employee dies, the remainder of his or her “fund” or “reserve” is then redistributed to the remaining retirees. Actuarial principles ensure that amounts annuitized and subsequently redistributed upon death are done in a fair and equitable manner. Age is used to compute life expectancies, probabilities of death, and the associated fair transfer values.
Participant accounts are adjusted upward or downward based on the trust’s investment earnings. Adjustments are also made to the accounts for mortality gains and losses. Thus, the participants bear all of the investment risk as well as the longevity and other actuarial risks. All the plan sponsor has to do is contribute the fixed amount per annum.
While there are certain issues that would need to be worked out for the tontine pension plans to work in an ERISA environment—mandatory qualified joint and survivor annuity (QJSA), qualified optional survivor annuity (QOSA), or qualified preretirement survivor annuity (QPSA) benefits, for example—most of these issues generally do not exist in public sector plans.
Can such a plan solve the public sector pension funding crisis? Not by itself. In order to accomplish that objective, existing underfunded levels would need to be shored up through increased contributions, investment earnings, and/or cuts to benefits. However, once the underfunding is shored up, the tontine pension plan would prevent such deficits from happening in the future. Going forward, the tontine pension plan may be just what the doctor ordered.