Mortality Drag --- So what!

But if the 65 year old would have got say 8% using the same cross subsidy as a 60 year old, but in fact only gets 7.2%, does that not explain the lower cross subsidy for the older person?

Rob Graham

No. The source you quote is not a particularly good explanation of what mortality drag is. Basically if you have a certain pension pot available at 60, then you can either convert it to an annuity there and then, or delay converting until you reach a higher age at which better annuity rates are available. But in the meantime you need an income to live on, and if you can survive without touching your pension fund, then there is no problem.

The problem arises if you derive income by draw-down from the pension pot, because it is going to reduce the value of the pension pot with which you eventually buy the annuity, and may reduce it by more than the benefit you will derive from improved annuity rates.

For example, if you have a £100k pot, you can turn it into £6340pa there and then. But if you delay to 65, you could get £7200pa only if the pot still stood at £100k then. Or you could get £6340pa if the pot had £88056 in it. If you draw down £6340pa in the 5 years before you buy the annuity, the pot will shrink to £68300, so even at 7.2% you will only get £4918 per year.

OK, that's witht taking into account that you will be investing the pot during those 5 years. It is possible to calculate the interest rate required for the return on this investment, to ensure that drawing down £6340 per year (in monthly instalments) will still leave at least £88056 in the pot at the end of the 5 years.

Mortality drag is the phenomenon which results in this required rate of return on investment to be higher the more you delay buying the annuity. Alternatively, if the rate of return remains constant, it means that the actual value of the annuity will be less the more you delay. But of course it all depends on how much income you actually take from the pot. If it's much less than the rate of return available, there won't be a problem (this needs to be a real rate of return, i.e. net of inflation). This is back to the old maxim of making sacrifices today in order to achieve an advantage tomorrow.

The thing is that because annuities include both investment returns and return of capital, annuity rates will always be higher than investment returns you're likely to achieve, so if you're to live off interest alone, you can never hope to "earn" more during the drawdown stage than during the annuity stage, unless you reduce the value of the pot.

Remind me:

1) What is the typical annuity rate at age 50 ? 2) What is the average stockmarket return over the last 25 years ?

Mortality drag is only a really big problem at more advanced ages, where the rates of mortality are quite high. At around age 70 - 75, mortality rates are around 2% a year. Mortality drag 'uses up' 2% a year of your investment return at those ages.

Also, at those ages, people tend to be more risk-averse, and 100% equity investment would be unlikely to be appropriate in those cases.

At younger ages, also, flexibility is more important, as circumstances are more likely to change unpredictably.

Income drawdown is far more likely to be appropriate at age 50 than at age

70 for these reasons.

"Miss L. Toe" wrote

Don't you really mean the following? :- "What *was* the typical annuity rate at age 50, in 1981/before ?" [Not "is"!]

I've no idea. If you are challenging my claim that annuity rates should always be higher than investment returns, I guess you are right to do so, but only because annuity provision isn't 100% efficient.

The younger the age at annuity purchase, the lower will be the annuity rate. In theory it will still always be higher than the rate of investment return, because an annuity basically works like a loan being paid off: In each period the pot grows by the investment rate, and then shrinks by the payout. In due course the pot will be empty when the annuitant dies, or is expected to, with cross-subsidies making sure the system keeps going when people unhelpfully die at the wrong age. The annuity rate can therefore be calculated much like mortgage payments: The annuity rate is equal to 12 times the monthly payment, divided by the initial size of the pot.

If the expected age at death for a 50-year-old is, say, 85, then the annuity rate is a function of the expected return rate. If that is say

6%, then I'd expect the annuity rate to be 12 x (1.06^(1/12)-1)/(1-1.06^-35) = 6.715%.

Of course that presumes 100% efficiency. But an annuity provider is not a charity. It wants to make a profit, and it is also underwriting a risk that the rate of return might drop below the 6%. So the provider makes charges, and these are reflected in lower annuity rates, and if the size of the charge required is greater than the margin of 0.715% above the 6% ROI rate, then the actual annuity rate offered to the prospective annuitant will be lower than 6%.

However, another way of looking at this phenomenon is to work out what rate of guaranteed permanent return a provider could offer. I.e. if long term average market returns are 6%, they may be able to offer their investors a guaranteed 5% return forever (not just for life, but forever, i.e. it would be heritable), if the 1% margin is enough to cover both their risk and their profit. If we do this, then 5% becomes the effective ROI rate, and annuity rates at any age should always be above 5%.

For fixed annuities, with guaranteed payments, the investment benchmark to compare against is fixed interest securities, ie government stocks and very secure corporate loans.

Both of which are in short supply and hence expensive, generating lower returns than they might in a more balanced market.

The other main reason I was challanging the claim that annuity rates should always be higher is risk premium. i.e. A greater return should be obtained on equities (on average) than on guaranteed bonds.

True

Well, to avoid comparing apples with pears, you probably need to look at unit-linked annuities. I believe a couple of companies still do these, but I'm not sure which.

I agree that the likelihood (based on what's happened in the past) is that equities will provide a better return in the future than fixed interest securities.