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Mortality drag – the invisible force
When drawdown was first introduced, a well-known actuary pointed out that comparing annuities with drawdown was not comparing like with like because annuities benefit from mortality cross subsidy whereas with drawdown there is no cross subsidy.
Mortality cross subsidy
Actuaries calculate annuity rates assuming people will live until their normal life expectancy. However, some policyholders will die before they are expected to and some will live longer than expected.
Insurance companies make a profit from those dying early and a loss from those living longer. They they use the savings from the early deaths to subsidise the income paid to those who live longer than expected.
This means that those who die before their normal life expectancy subsidise those who live longer than expected. This is called Mortality cross subsidy.
If an annuity purchase is deferred, the annuity payable at a future date will be higher because the policyholder will be older. However, an invisible force called mortality drag slows down this rate of increase.
Mortality drag is the negative effect of missing out on mortality cross subsidy if an annuity is deferred from one year to another. It is expressed as the additional investment return needed year by year in order to maintain the annuity purchasing power assuming the underlying annuity rate remains constant.
Let’s look at a simple example where a £100,000 fund could purchase a single life annuity for someone in good health at age 64 paying £5,205 per annum (March 2018). The table below shows how much a pension drawdown fund needs to grow each year in order that an income of £5,205 can be paid each year and at the end of the year so an equivalent annuity could be bought assuming no change to the underlying annuity interest rate.
If you want to make the most of pension freedoms you should start planning ahead and make sure your financial affairs are in good shape in the years running up to retirement.William Burrows
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