The Chris Cook Economics 3.0 column
Pensions are in a mess. Private sector schemes are in deep trouble not only because corporate income has fallen and employers “can’t afford it” but also because the fall in investment income has led to the need for massive top-ups in funds. Public sector pensions are of course potentially a huge burden on the long-suffering taxpayer. So whether the middleman is the State, or the financial services circus of pension funds, fund managers, advisers and consultants, the outlook is equally grim.
Readers of my posts will know that I see no future in the 21st century networked Economy 3.0 for intermediaries, but rather a transition to direct connections between end users – in this case pension investors and pension recipients – and I believe that partnership-based frameworks will enable such a transition.
Now, by way of risk disclosure statement, even though I have a background in financial services, I confess I have always found the subject of pensions a difficult one. But neverthless, I feel qualified to chuck a couple of ideas into the policy pot.
In the second half of the 17th century the Neapolitan banker Lorenzo Tonti made popular the mutual insurance scheme known as the Tontine. The idea is that each investor pays into the Tontine and then receives an annual dividend in respect of his proportional share in the resulting pool. When investors die, their shares are reallocated among surviving investors, and the process continues until only one investor survives.
Early uses of the Tontine were by the state, which used Tontines to raise capital, and kept the capital sum when the last Tontine member died. Indeed, Britain’s Nine Year War with France was part funded by a Tontine begun in 1693. However, this funding use by the state soon ceased after members started to “game” the system for example by nominating as beneficiaries 5 year old girls with a much longer life expectancy than the sponsors anticipated.
However, the use of Tontines for life insurance was introduced in the US after the civil war. The idea was that part of the premium went towards conventional life insurance, and the rest into a pool which was then divided up after a predetermined period. This was hugely popular, and the Equitable Life Assurance Co responsible for popularising it lives on to this day in the form of Axa Equitable Life Assurance Co.
The demise of the schemes in a celebrated (and trumped up) scandal in 1905 appears to have been a coup inspired by JP Morgan (himself – not the company) and other board members of the company – who clearly saw no need for unnecessary payments of capital to beneficiaries other than themselves – and as a result this form of mutual investment has been proscribed in the US in favour of conventional insurance ever since.
Using a partnership framework it is possible to provide for premium payments to be paid into a “Pool” held by a custodian entity on behalf of the members. All income from investments made by the pool would be reinvested. A service provider member would then manage the operation of the pool. There is nothing new about such a service provider arrangement – ships are insured mutually by “P & I Clubs” of ship owners which are managed by specialised service providers such as Thomas Miller.
It is interesting to consider how such a Dead Pool mechanism might operate. Possibly the pool could be subdivided as between “cohorts” born in a particular year, and then pooling would be operated between members born in that year.
When a member dies then a part of his/her proportional equity share in the pool would go to his estate, with the balance remaining in the pool. As the cohort diminishes with time, it might be necessary to combine cohorts into (say) five or ten year cohorts.
There would be a cut off – retirement – date when premium payments in cease, and dividend payments out begin. This process would have to be managed by actuaries in the same way that annuities are managed now. But one of the beneficial aspects would that excess “orphan” funds will no longer come about which may then be appropriated by shareholders.
One of the benefits of this mutual approach is that the income of the beneficiaries would rise as they get older, which is of course when they most need it. Another is that since this methodology is essentially the form of Islamic insurance known as “takaful”, it would be generally acceptable to Muslims who hold that conventional life assurance and annuity contracts are forms of gambling, and hence unacceptable.
Economy 3.0 – Disintermediation
Once again we see that by sharing risk and reward within a partnership framework, excess profits to rentier shareholders of life insurance intermediaries are not in fact necessary, and that the profits currently accruing to them could instead be applied to better returns to scheme members and pensioners.
In fact, it is not widely appreciated – until disasters hit – quite how undercapitalised insurance intermediaries are. We recently got a flavour of this with AIG’s disastrous over issue of credit insurance swaps – which are credit insurance in all but name – but we have seen, with asbestos and AIDS claims to the firefront, that many insurers have been far more undercapitalised for the risks run even than the banking system.
Using such a disintermediated architecture reduces the capital requirement to the minimal level necessary for operating costs. Companies would no longer need capital to pay claims or dividends.
As for the investment income of insurance companies – where many companies are in fact currently surviving only because they have not written down their investments to their true value – that is another story. A new generation of investments in public assets with a reasonable index-linked return would go a long way to solving this problem.