Welfare impact of flexible payouts and adverse selection in tontines

The welfare impact of allowing flexible payouts in a tontine is investigated. This is achieved by simulating an open tontine with consistent membership numbers. Certainty equivalent payouts are used to measure welfare loss compared to an equivalent actuarially fair annuity. In the base scenario with no flexible payouts or adverse selection, welfare loss is 0.56 per cent compared to the equivalent annuity, of which more than 80 per cent is due to systematic mortality uncertainty and less than 20 per cent is due to idiosyncratic mortality uncertainty. Where biased (adverse selection) flexible payments are present, additional welfare loss is also present. However, with appropriate constraints on flexible payout structures, the average welfare loss is smaller than the loading applied to an equivalent annuity. This investigation is presented in an administratively feasible structure, and hence the key findings of this paper can be broadly applied by product providers keen to innovate.