Tontines vs Existing Solutions
Defined Benefit (‘DB’) Pensions:
DB Pensions are increasingly unavailable in Europe.
As bond yields continue to decline, and life expectancy continues to rise, the amount of capital needed by a DB Pension to fulfill its promises of fixed lifetime incomes has become unaffordable to employers & governments whom have historically funded these schemes.
Defined Contribution (DC) Pensions:
DC Pensions were introduced in the 1980’s as a successor to DB Pensions. The majority of Pillar II (Employment related pensions) & Pillar III (Personal Pensions) are now DC pensions throughout Europe.
A typical DC Pensions is a savings account into which a consumer can ‘accumulate’ capital directly out of their pre-tax income with any growth of the capital remaining untaxed until the consumer reaches retirement at which point they will start paying income tax on amounts withdrawn from the account as they ‘decumulate’ their balance.
If the fees are reasonable, DC Pensions are excellent for accumulation savings but they are perilous as a decumulation tool due to the presence of several risks:
Longevity Risk: The consumer needs to draw down capital to live on. Even if the consumer draws teh income down prudently, if they live a long time then there is an extremely high likelihood that the capital will be exhausted and the consumer will be financially destitute in old age.
Sequence of return risk: If the consumer retires just after a market downturn or in a very low return environment, the capital that is drawn down & spent now never be able to recover its value later and so their risk of financial destitution is markedly increased.
Annuities are the original DB Pensions having been invented by the Romans as a means of solving Longevity Risk for retired legionnaires. Other than in those periods of history when tontines were offered, annuities have been the default personal pension products for solving Longevity Risk.
Annuities, generally now offered only by insurance companies, have attracted a widespread reputation as ‘the most hated financial product in the world’.
This antipathy can be primarily blamed upon:
- Low-Interest Rates: To offset their liabilities, insurers are required to hold corresponding income generating assets such as bonds. In a low interest rate environment, this has a devastating effect on annuity yields.
- High Costs: Research shows that up to 30% of a savers capital is absorbed by the hidden costs of the income guarantees, further reducing annuity yields.
- Perceived Unfairness: Consumers are aware that annuities are always priced to make a profit for the shareholders of the insurance company at the expense of the retiree. This creates the same feelings towards annuity salespeople as a homeowner would have to an investor that offered to buy their family home at a 30% discount to the market price.
- Lack of Indexation: The fixed/guaranteed nature of an annuity payment tends to overlook the damage to purchasing power caused by inflation. Whilst index-linked annuities can sometimes be found, their initial yields are even lower than fixed annuities.
Target Date or ‘Lifecycle’ Funds:
The 1990s saw the launch of a new breed of accumulation/decumulation savings products which offered a key improvement over regular DC Pension accounts.
As shown above, DC Pension accounts expose retirees to ‘Sequence of Returns Risk’. Lifecycle funds largely mitigate this risk for savers by overweighting risk assets such as equities when the saver is younger, but progressively re-balancing to more defensive assets such as bonds as the saver gets closer to their retirement date.
Whilst this was a significant improvement, Lifecycle Funds still fall short of addressing several consumer needs:
They offer zero Longevity Protection: The balance will run out if the consumer lives a long time.
By switching a savers portfolio to bonds in a zero interest economic environment and with no other source of income in the portfolio:
- The drawdowns of the saver will directly reduce their capital balance and thereby increasing their risk of running out of money,
- In a high inflation environment, to maintain their purchasing power, the consumer will need to increase their capital drawdown rates at exactly the same time that the market value of their bond portfolio will have fallen.
As the saying goes, the only guarantees in life are death and taxes.
What makes Tontines unique as an asset class is that they guarantee a source of income unavailable from any other financial product: mortality credits.
The assurance of this future source of income has led to several research papers from the Swiss Federal Institute of Technology which concluded that when a risk-averse saver joins a tontine pension, their ‘equivalent pension wealth’ rises by 87% ‘with no added risk’.
Therefore, a Tontine PEPP is the only PEPP that can offer the following features in a single wrapper for an all-in fee of 1%:
- A tax efficient, portable retirement savings.
- Guaranteed enhanced income from mortality credits which provides natural protection from Sequence of Return Risk.
- Enhanced income from stable dividend paying asset classes such as ELTIFs.
- Complete Longevity Protection for individuals.
The advent of the PEPP, with its high governance standards and fee caps is a major win for consumers, especially those that exercise freedom of movement within the EU.
The greater benefit for consumers however may come from the fact that the PEPP Regulation now unleashes the potential for substantial innovation in the European Pension sector.
PEPP means that Tontines can once again reshape and redefine the pan-European pensions sector as they did in the 17th & 18th century. Once the standard is set in Europe, these next generation pension products will be in demand all over the world.
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