What is Mortality Drag
26-Oct-09 by Tim Moore
Put simply, if you purchase an annuity an income will be payable until death.
Some annuitants will die earlier than expected and so a ‘profit’ arises which is passed on to the remaining annuitants and is reflected in the overall annuity rate.
An insurance company will take into account your life expectancy (or “mortality”) when calculating the amount of annuity that it is prepared to offer you.
In short, people who live longer than expected effectively gain from those who die earlier than expected. This effectively subsidises those annuitants who live longer.
However, this subsidy is not present with Drawdown and so to provide a comparable income a higher investment return will be required. The older a client becomes, the higher the cross subsidy will be, therefore the investment return must become even higher in later years.
If you choose to take income withdrawals, you would not benefit from the allowance made within annuity rates for those who die early.
Consequently, when looking at the investment return needed to match the annuity you could have bought at outset, an additional return will be required to make up for this allowance.
For example, a single male who chooses to take income withdrawal at age 60 and continues to take withdrawals until age 75, would need an enhanced investment return of about 1.8% per annum if he were to buy the same annuity at age 75 as he could have done at 60.
The effect of this allowance is not the same for everyone and tends to have the greatest impact on single men. However, it is a factor that should be taken into account in the overall decision as to whether income withdrawal or annuity purchase is the most appropriate option.
