T C A Srinivasa-Raghavan: From tontine to Montine

OKONOMOS

Few people have heard of Lorenzo Tonti, a banker who lived in the mid-17th century. In 1652, this Tonti chap came up with an idea for raising money to fund public goods. The financial instrument that was thus born came to be known as the tontine.

France was in serious financial difficulties in those days. It was finding it hard to raise taxes but badly needed more money all the same. It, therefore, needed a new idea. Tonti provided it with one.

Just as Montek Singh Ahluwalia thinks using a part of the forex reserves for funding infrastructure is a top-notch idea, Tonti also thought his idea was "a gold mine for the king....a treasure hidden away from the realm." Like Monty, Tonti too was persuasive.

Louis XIV was ecstatic and endorsed the idea. It consisted, basically, "of an interesting mixture of group annuity, group life insurance, and lottery" say Andreas Lange, John A. List, and Michael K. Price in a recent paper*. The instruments came to be known as the tontine (whence my suggestion for India, the Montine).

"In the seventeenth and eighteenth centuries the tontine played a major role in raising funds to finance public goods in Europe," they say but add unkindly that "today it is rarely encountered outside of murder mysteries."

Tonti's idea was simple. He proposed a contingent annuity with survivorship benefits. Subscribers were grouped into different age classes and would make a one-time payment of 300 livres to the government.

"Each year, the government would make a payment to each group equalling 5 per cent of the total capital contributed by that group. These payments would be distributed among the surviving group members based upon each agent's share of total group contributions. The government's debt obligation would cease with the death of the last member of each group."

A great deal, of course, depended on how the tontine was designed. The idea was to incentivise private individuals or institutions to take a bet on something that would eventually finance something risky but also something very profitable.

Indeed, sometimes the returns could be so high that contributors ended up killing each other to increase their shares. The authors say that tontines have since been banned in the UK and the US.

The key to all this was the voluntary nature of the contribution. This study adds to the literature on the voluntary provision of public goods by evaluating the performance of the tontine and its optimal design.

The major theoretical results are as follows:

The optimal tontine for agents with identical valuations of the public good consists of all agents receiving a fixed "prize" amount in the first period equal to a percentage of their total contribution;

Contribution levels in the optimal tontine are identical to those of risk-neutral agents in an equivalently valued single prize lottery;

Contribution levels for the optimal tontine are independent of risk-aversion, and thereby outperform lotteries when agents are risk averse.

If agents are sufficiently asymmetric in their valuation of the public good, equilibrium contribution levels are larger under tontines than any lottery. In particular, one can obtain full participation in the tontine mechanism compared to only partial participation in a lottery.

Tontines could even be insured. Policyholders were able to secure life insurance plus create a retirement fund. Survivors would receive a generous rate of return on these investments if a large proportion of other group members were to pass away (whence the incentive to murder) or allow their policies to lapse. It was a low-risk, high-yield investment fund, which could be paid in instalments.

Should India try a variation on the theme? If the incentive to kill off fellow contributors is removed, it may not be a bad idea, especially if it is offered to Hindu Undivided Families.

The best way to go forward might be for the Planning Commission and the Reserve Bank of India to jointly fund a study on the use of tontines in India. The two have an equal and opposite vested interest and the study may actually turn up something usable.

*Using Tontines to Finance Public Goods: Back to the Future?, NBER Working Paper No. 10958, December 2004