Top stocks to invest in – Book review: King William’s Tontine

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King William’s Tontine: Why the Retirement Annuity of the Future Should Resemble Its Past. 2015. Moshe A. Milevsky.

Reviewed by William J. Bernstein

This is a most curious book: a deeply analytical look at a long-forgotten financial instrument, embedded in a matrix of first-rate financial history and served up in voluble, conversational prose. Think Paul Samuelson meets Bill Bryson. Milevsky’s wide-ranging interests and innovative mindset impress almost as much as his generosity, which liberally credits current and previous researchers in the field.

Most will dimly recall tontines from Finance 101: an annuity-like structure in which the surviving beneficiaries enjoy an ever-increasing payout as mortality shrinks the member pool, with the last surviving beneficiary reaping the entire income stream.

The instrument was named after its originator, Lorenzo de Tonti, a consultant to Cardinal Mazarin, chief minister of Louis XIV. Over the centuries since he described the scheme around 1653, governments and entrepreneurs have spawned myriad variations on the theme. Many made little actuarial sense. Before the 19th century, for example, most of the plans separated out the nominee from the annuitant, with an older adult typically picking a child as the nominee, on whose lifetime the payout would be based. De Tonti’s original plan envisioned paying out a fixed percentage of the total principal (from which an ETF-like 0.125% administrative fee was to be subtracted) to the annuitants and, presumably, their heirs, according to the lives of the nominees. The scheme separated out nominees by age: 0–7, 8–14, and so forth. As they died, the remaining annuitants were to receive proportionately higher payouts, with the annuitant of the last nominee getting the entire payout stream.

De Tonti’s original plan was thus a kind of “survivors take all” annuity. It was never implemented, but the concept inspired an entire literary genre in which tontine participants plotted each other’s murders. The most famous examples include Robert Louis Stevenson and Lloyd Osbourne’s The Wrong Box and a Simpsons episode titled “The Curse of the Flying Hellfish,” named after Grandpa Abe and Monty Burns’s World War II unit. (After uncovering a case of priceless paintings, they decide to consign it to the last survivor. Years pass, and only Monty and Abe remain; Monty takes out a contract on Abe, who escapes by hiding in Bart’s room.) Alas, history reveals no real-world examples of such skullduggery; rather, tontine malfeasance frequently ran in the opposite direction, with heirs concealing an annuitant’s death or investors systematically seeking out the healthiest young nominees. In any case, almost all subsequent schemes truncated payment increases long before the annuitant pool fell to one.

Within a few decades after de Tonti’s proposal, both the French and the British governments implemented variations on his scheme, and a description and detailed analysis of the version launched by King William’s ministers in 1693 forms the core of this book. Annuitants paid £100 for shares upfront and chose a nominee, who was usually (but not always) young and healthy, and if an annuitant or a nominee died, his share of the initial payout — 10% of the total asset pool for the first seven years and 7% thereafter — went to the survivors. As the survivor pool shrank, the cash payout increased proportionately. When seven nominees/annuitants remained, payments were capped, and when the last died, the principal reverted to His Majesty’s Treasury.

Why, then, did tontines disappear? In England, apparently, they disappeared for lack of interest; the initial subscription to King William’s tontine fell well short of its £1 million goal and thus triggered a conversion option to a much more favorable 14% fixed annuity. Within a decade, the English government offered a dizzying array of attractive annuities and fixed-debt securities, many of which were melded together in 1751 into its famous consolidated debt, the consols, which endure to this day.

The reasons for the disappearance of the tontine elsewhere were more lurid. Milevsky blames the extinction of French tontines on the rampant hyperinflation of the revolutionary period, leaving tens of thousands of annuitants with payments in worthless assignats. No doubt this was a factor, but if it were the major cause, it would have put the French off all debt instruments. This did not happen; after Napoleon replaced the assignat with the more solid franc in 1803, rates plummeted to single digits, and by 1830, they had fallen below 5%.

The French tontine did vanish — though not with a whimper. In the 1790s, François Lafarge set up a fantastical apparatus into which investors paid ₣90, either in 10 annual installments or as one sum, which sat fallow for a decade, at which point lots were drawn and the winners were awarded a yearly payment of ₣45. The losers had to wait until sufficient numbers had died to allow for their payments to begin. The state was to receive annual payments in excess of ₣3,000 per year; as the investors died out, the state would increasingly — and eventually fully — benefit from the income stream and principal.

The plan — the notorious Caisse d’épargne et de bienfaisance — like most Ponzi schemes, initially proved a smashing success, but official suspicions prompted an investigation that resulted in its exposure. The government closed down the Caisse in 1809; subscribers received sous on the franc, and France effectively banned the tontine.

The American “tontine” story proved even more sordid. It started with a titanic battle between the two great opposing personalities of the late 19th-century insurance industry: the conservative, upright Frederick Winston, president of Mutual Life Insurance Company of New York, one of the nation’s dominant companies, and the upstart Henry Hyde, the brash, flamboyant former Mutual clerk who assumed leadership of the Equitable Life Assurance Society of the United States, known as the Equitable, with the goal of overtaking his former employer.

In the mid-1860s, Hyde somehow became aware of de Tonti’s scheme, which he proclaimed a “discovery in life insurance.” Strictly speaking, Hyde’s invention was not a tontine at all but, rather, a life insurance policy with a tontine kicker: the insured paid their premiums, and if they passed away, their survivors received the death benefit; if payments lapsed, no benefit was paid. So far, so good.

In those days, policyholders also expected a dividend on the investment account. Hyde’s “tontine” insurance suspended this payout for 10, 15, or 20 years, depending on the policy (and Hyde’s whim), after which surviving policyholders received all of the juiced-up principal. This part of the insurance structure, in which periodic payments ended with a lump-sum distribution, was, in fact, the precise opposite of a traditional tontine. Further, “non-surviving” meant not only those who had died but also those who had stopped making payments; miss even one, and you were out of the pool. The product, through a combination of modest monthly payments and its appeal to the gambling instinct, initially spread like wildfire. Over the next four decades, the Equitable and its imitators sold approximately 9 million policies — two-thirds of the nation’s outstanding insurance contracts. Alas, they also spawned a growing army of policy owners whose life savings had been wiped out by a single missed payment.

The huge piles of cash produced by the tontines’ deferred payout structures proved too much temptation for the issuers — especially the profligate Hyde. As the funds in the investment account accumulated, they found their way into directors’ and agents’ pockets. Worse, this loot also migrated into the hands of judges and legislators, who reciprocated with judgments and laws that stymied burned policyholders.

Within a decade of Henry Hyde’s death in 1899, control of the Equitable, now the nation’s largest insurer, passed to his young son James, whose high-flying lifestyle provoked a boardroom crisis that in 1906 triggered the formation of a New York joint assembly–senate investigative panel, the Armstrong Insurance Commission.

One can gauge the historical import of such committees by the later rise to prominence of their chief characters. Few today know the name of Arsène Pujo, the chair of the House subcommittee whose 1912–13 investigation of the money trusts gave birth to the Federal Reserve, and only finance buffs recall Ferdinand Pecora, the chief counsel for the 1933 hearings of the Senate Committee on Banking and Currency that midwifed the foundation of today’s security laws.

In contrast, the 1906 investigation riveted the nation and launched into orbit the career of its chief counsel, Charles Evans Hughes. By that point, the scandal focused on company-related political graft and embezzlement, not on the tontines themselves. The resultant legislation did effectively prohibit them, but it was a mere footnote in the encompassing insurance laws that followed. So influential were the hearings that within months, Hughes defeated William Randolph Hearst for the New York governorship (the only Republican to garner a statewide office in that year), followed by stints, successively, as associate Supreme Court justice, narrowly unsuccessful presidential candidate, secretary of state, and Supreme Court chief justice.

As mentioned, the book’s tone is agreeably conversational, as close to a romance novel as life-cycle theory gets. Most authors, in discussing modern Sweden’s tontine-like pension structure, would be tempted to label it “labyrinthine” or “difficult to grasp.” Milevsky, however, declares more simply, “I must admit; I don’t quite understand all the details.” Coming from someone with the author’s quantitative horsepower, that’s a description of complexity this journal’s readers will respect.

Milevsky also has a deadeye for compelling narrative. One example is his exposition of the politics-of-tontine structure of Israel’s kibbutzim, an illustration of the way social solidarity occasionally trumps the law of large numbers. Government bureaucrats, steeped in conventional actuary science, proposed merging the individual tontine-like annuity streams of the nation’s kibbutzim, some of which were quite small, so as to reduce payout variability. The backlash from kibbutzniks, who had a personal interest in the well-being of their fellow members — as opposed to the faceless mass of members of other, frequently rival, kibbutzim — was fierce. As of the book’s writing, the issue had not yet been resolved. Another narrative describes how a young English servant named William Shakeshafte benefited from a tontine-like feature of his master’s will. We know him today under a different surname — Shakespeare — and it seems likely that without his tontine-like income, he would not have been able to move from Stratford to London to act and write.

Occasionally, Milevsky’s enthusiasm gets the better of him, as when he devotes three full pages to historiographical problems attendant on the staggered late-medieval European transition from the Julian to the Gregorian calendar. While this is the best explanation of the problems resulting from a 365.2424-day solar cycle I have come across, a finance book may not be the best venue for even so delicious a gift. More seriously, his detailed, compelling, and long exposition of the events surrounding the Glorious Revolution of 1688 leaves out its critical institutional denouement: the subsequent revolutionary settlement. Among other things, this agreement exchanged parliamentary supremacy (i.e., abolition of the divine right of kings) for a stable excise base. As pointed out by Douglass North, the elements of this compromise constituted one of history’s happiest synergies, opening the way for the robust market in government debt and, ultimately, England’s towering financial and geopolitical dominance.

Milevsky brings the book into the modern world of life-cycle investing with his own theoretically appealing version of the vehicle, which he calls a “natural tontine,” whose payout percentage is precisely tuned to the survival curve of the annuitants and thus yields a flat dollar payout throughout its life. In order to avoid intergenerational (and intergender) transfers, he suggests pairing “like with like” — that is, restricting the pools to those of the same age, sex, and, if possible, health status.

This type of investment is essentially identical to a well-designed annuity with one important exception: the bearer of the actuarial risk. For a conventional annuity, that bearer is the issuer, which must be compensated for taking that risk. (It must also perform detailed actuarial analysis, which does not come cheaply.) With a tontine, it is the annuitants themselves who bear the risk. If they underestimate their cohort’s survival, they will pay for it in their advanced old age, when they can least afford it. (The opposite occurs, of course, if they overestimate the cohort’s survival.) In return for this uncertainty, tontine owners not only receive a higher payout but also benefit from greater transparency.

This idea is intriguing and should be seriously entertained by policymakers. Unlike many annuity enthusiasts, Milevsky is pleasantly eclectic about the place of the tontine in optimal life-cycle planning, stopping just short of a 1/N recommendation among stocks, bonds, state/private pensions, and annuities/tontines. (An additional point that he could have made for US readers is that the purchase of an annuity or tontine makes little sense without first deferring Social Security until 70 because the inflation-adjusted payout of this maneuver is likely to be far higher than even that of a zero-cost tontine.)

The author is alarmingly laissez-faire about just who should be providing the vehicles. Noting that Adam Smith had favorably mentioned the idea in Book V of The Wealth of Nations, Milevsky opines, “I would let the market and Adam Smith’s invisible hand sort out the best tontine design. After all, he was a fan, as well.”

Careful readers of the book, though, may not be so sure; recall how the Caisse d’épargne et de bienfaisance and Henry Hyde ended the tontine eras in France and the United States. Have insurance companies become any more trustworthy since 1906? Remember, it is the industry that today gives us equity-indexed annuities (recently rebranded as fixed indexed annuities), variable universal life insurance, and variable annuity subaccounts wrapped inside IRAs. And if you do not recognize today’s army of Henry Hydes, then you have not been reading the Wall Street Journal (or, better yet, Investment News) carefully enough. (A curmudgeon might even point out that the insurance industry, along with the rest of Wall Street, generously funds research and disburses no small amount of consulting fees in the groves of academe.)

In the current Kafkaesque regulatory environment, the insurance salesman owes his fiduciary responsibility not to the customer but, rather, to the insurance company. Even the informed retiree who contacts an agent with the intent of purchasing a plain vanilla annuity or tontine is likely to walk out with something far more opaque, expensive, and ultimately toxic to her well-being. It is not too much of an exaggeration to say that trusting the insurance industry to efficiently execute the tontine is akin to having John Dillinger design your bank safe. Until regulators apply a fiduciary standard to the industry, caution about any new product should be the order of the day.

Nor does one have to invoke overt malfeasance to imagine how the invisible hand might push even the most carefully designed tontine scheme seriously off kilter. A structure in which the policyholder, not the company, bears the actuarial risk incentivizes the latter to sell tontines that, by using overly optimistic assumptions, overpay upfront and self-combust later. Finally, it is no coincidence that all three of the successful modern tontine-like structures Milevsky cites — the Swedish pension system, the kibbutzim schemes, and TIAA-CREF’s adjustable annuity payouts — are noncommercial enterprises. The author himself implicitly raises the issue of whether for-profit enterprises can supply optimal longevity insurance by asking, at the book’s end, “Where is the Vanguard of retirement income for the middle class masses?”

King William’s Tontine entertains and, by asking why retirees should not be paid handsomely for bearing a little actuarial risk, informs our response to the looming retirement crisis in a way that no other book does. It should be read — with pleasure — by anyone with a personal or policy interest in this vital area.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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