Why tontines may beat annuities for future retirement planning

What are tontines and why their time has come for financial planning

Book excerpt: Age-old financial instrument beats annuities and should be revived

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Moshe Milevsky_322

Author Moshe Milevsky makes his case to bring back a financial instrument from the past.

SPEED READER

Book: King William’s Tontine: Why the Retirement Annuity of the Future Should Resemble its Past

Author: Moshe A. Milvesky

Publisher: Cambridge University Press

Price: $56.43 for 257 page hardcover ($39 for the paperback)

WHO IS IT FOR? Anyone interested in discovering new ways to help us fund retirement—and if you love history, all the better.

WHAT IS A TONTINE? Part annuity, part lottery, and part hedge fund, the tontine—which recently celebrated its 360th birthday—offered a lifetime of income that increased as other members of the tontine died off and their money was distributed to survivors. The tontine is a slightly macabre concept that involves the pooling of investments in such a way that those who die end up subsidizing those who keep living.

Tontines: The retirement plan of the future?

WHY WE LIKE IT. Who would have guessed that a tontine financing scheme invented by a 17th Century Italian businessman might hold the key to retirement security for today’s workers? The investment takes its name from Lorenzo de Tonti, an exiled Neapolitan banker living in France who, in 1653 conceived of a plan to replenish the royal treasury, depleted by the Thirty Years’ War.  The book closely examines the important topic of how our aging planet will confront and manage the risk of outliving our money. Milevsky’s book is a sharp and witty look into how others dealt with the topic in different historical periods and give us an in-depth look at the history of the tontine, as well as numerous anecdotes to make it highly entertaining as well as enlightening. Plus, Milevsky makes a very persuasive argument for why the financial industry and governments have a new look at this financing technique.

WHY ELSE DO WE LIKE IT? Milevsky goes to great lengths to explain the difference between the tontine and an annuity, which is a great financial literacy education in itself. For instance, with a tontine, the total interest paid each year to those within the group stays constant, while with a life annuity, as people die, the total paid out to the group declines over time.  As well, with a tontine, payments to those who survive increase, and the longer they live the more money they get. But with a life annuity, payments and income to survivors stay constant.

ACTION ITEM: Whatever your age, if you’re preparing for retirement—or simply enjoy reading about interesting financial concepts and products—this book will give you a firmer grasp of retirement planning. Smart financial reading at its best.

KEY TAKEAWAY: “In some sense, I am hoping the readers will help advocate—implicity or explicitly—the acceptance of tontines as useful and valuable products worthy of reintroduction into society after almost a century of wandering in the wilderness.”   – Julie Cazzin

 

BOOK EXCERPT 

In the last decade of the seventeenth century, King William’s main priority and existential preoccupation was to secure the funds he needed to pay his troops and continue his campaign against France. William—who was a military commander and master strategist – still had outstanding debts to settle from his previous battles, including the 21,000 men he had hired to accompany him to England in 1688. Money was tight, and King Billy was in a bloody bind. I must admit that the story of an English monarch in need of money might sound a bit distant and incredulous to anyone in the twenty-first century. But then again, even Queen Elizabeth II, who ascended the throne in 1952 and has a personal net worth of more than £300 million ($480 million), has monarchical financial problems and disputes with Parliament over who should pay for what. In early 2013, a parliamentary committee questioned her household’s (over)spending, and for a brief period in 2013, the queen applied for welfare – yes, welfare! – to pay for the upkeep on some of her palaces. Presumably, the future King Charles III (her son), the subsequent King William V (her grandson), or even future King George VII (her great-grandson) will have similar run-ins with Parliament.

But three centuries ago—when the beginning of our story takes place—the Crown’s finances were even more precarious, precisely because they were subject to the whims of Parliament, which controlled all the purse strings. Yes, the monarchs owned land and were entitled to live in castles – and the Orange family owned large tracts in the Netherlands – but cash flow and income weren’t easy to obtain, especially to finance a war. The now-common practice of making the monarch accountable to the English Parliament directly – and the English people indirectly – was one of the great constitutional achievements of the late seventeenth century.

Sure, a millennia or two ago, kings could do as they pleased and seize whatever they wanted or desired, whenever they wanted, but not so by the end of the seventeenth century. If a monarch needed more money—whether to wage war or provision mistresses—he needed Parliament to authorize and approve the additional funds. Now, of course, Parliament couldn’t really order the “creation” of money by printing, as it does today. Its only source of revenue was taxes, including land tax, customs tax, and excise tax, as well as taxes on salt, wine, spirits, tobacco, and even births and marriages. Requisitioning or raising additional funds today requires increasing taxes, and, naturally, as the elected representatives of (some fraction of) the people, Parliament is reluctant to do so, especially for wars that aren’t widely supported.

So, I now get to my main story.

William got his money from Parliament in the end. And in its attempt to raise funds to fight William’s war against the French, the English Parliament authorized something virtually unheard of within the empire; something that was to change the economy forever – a financial revolution according to some: they decided to borrow money by issuing long-term government debt.

The plan was that creditors would voluntarily lend (aka invest) a minimum of £100 each toward the war effort, and the government—not the king or any one person, the actual government—committed to pay interest on this £100 note for the next ninety-nine years. The Act of Parliament authorizing the ninety-nine-year loan was called the Million Act, which, as you guessed, was an attempt to get 10,000 Englishmen to (lend £100 or more each and) contribute £1 million to fund King William’s war. To put this number in perspective, £1 million in the year 1693 would be equal to between £100 to £500 million today, depending on wage and price inflation assumptions in 2015. Relatively speaking, this was a large sum of money.

At this point you must be wondering to yourself: “That’s it? They borrowed money to fight a war? Is that revolutionary? Heck, the U.S. federal government owes $18 trillion in the year 2015, for heaven’s sake!”

Well, part of the answer is that yes, this sort of scheme was a big deal in the last decade of the seventeenth century. Up until 1693, to be precise, the English as a people, governed by Parliament had never borrowed long-term funds the way it is practiced today. Yes, individuals had borrowed money for millennia, kings and queens had borrowed money, and even corporations—which did exist, mind you—had borrowed money, but not a nation.

To be perfectly honest, the real interesting story here is how Parliament implemented the borrowing scheme known as the Million Act and the type of debt they issued and committed the country to paying. This wasn’t your grandfather’s savings bond.

At a broad level—and I’ll get into much more detail later—the way the scheme worked was that in exchange for each £100 investment, the government committed itself to pay 7% interest until maturity of the so-called bond. So, the lenders were receiving interest payments of £7 per year for ninety-nine years, which sounds and smells awfully like a very long-term bond. But – and this is key—if and when investors owning the individual bonds died, they couldn’t – I repeat, could not – bequeath the share or bond units to their children, friends, or loved ones. Instead, the £7-per-year interest they would have been entitled to had they still been alive was forfeited and distributed to the other investors who were still alive. For the sake of example, if twenty years later half of the original £100 investors had died and half were still alive, then each surviving investor would now receive £14 interest in that year, which is double their first year’s interest payment. In thirty years, if three-quarters of the original investors had died, then all surviving investors would receive £28 interest (or a payout yield of 28%) in that year alone. And in the end, in theory, the longest-living survivors would get all the interest income on the proverbial table. Think of the last hand in a poker game. Winner takes all.

This ladies and gentlemen, is a tontine scheme – and it was the first time it was launched nationally in England. King William III used tontines to fund and pay for his war.

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