Mortality drag
Encyclopedia
Mortality drag is a term used, in reference to lifetime annuities
, to describe a negative impact that is experienced when an annuity purchase is delayed on a fund from which regular withdrawals are being taken by an individual. It is the increasing risk of falling annuity rates, and grows exponentially as an individual continues to defer an annuity purchase. In practical terms it represents the extra investment return a customer has to achieve to justify not annuitising a pension fund.
company that agrees to pay a regular payment over the expected lifetime of an individual. This payment may be based on interest rates or returns on investments, and will take into consideration costs (and profits). It may be helpful to think of it as a loan in reverse, from the perspective of the individual purchasing the annuity. Those who live longer than the mean
lifespan of an annuity population are effectively subsidised by those who die earlier and the insurance company usually assumes the risk of making this work based on actuarial
assumptions. This is known as a "cross subsidy". An individual may therefore suffer a "mortality loss" or "mortality gain" based on when they actually die. This is a risk they take on board in exchange for a guaranteed income for the rest of their (uncertain) lives.
In practical terms, those who invested instead of purchasing an annuity may gain more from the growth of the investment than they lose in the delayed annuity rate. However, where an individual decides to take withdrawals from a given lump sum before buying an annuity, the impact of mortality drag becomes very significant and increases exponentially with age.
For example, using imaginary actuarial assumptions, an individual with $100,000 could buy an annuity with an underlying interest rate after costs of 5% that would give them $8,024 at the end of each year based on a mean
life expectancy of 20 years. Instead, they invest in an investment with a fixed return of 5% and take $8,024 at the end of each year. Three years later they use the residual investment, now worth $90,466, to buy an annuity. The mean remaining life expectancy according to the mortality tables used by the insurance company will not be 17 years but longer. Let us suppose it is 18 years. The annuity that can now be purchased would give $7,739 each year. In order to offset the reduction, the alternative investment used for three years would have had to return 5.47%. If an individual waits longer than three years, the additional growth required will increase over time, reflecting the exponential effect of mortality drag.
an Unsecured Pension (USP), still popularly referred to as income drawdown, permits an individual to make withdrawals from a private pension fund from a permitted age before buying an annuity. The maximum level of withdrawal is controlled, but care must also be taken to maintain the fund at a level that can still buy an equivalent or better annuity in the future. The risk of reduced general annuity rates in the future must be considered and mortality drag increases exponentially as a person gets older.
Life annuity
A life annuity is a financial contract in the form of an insurance product according to which a seller — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer in exchange for the immediate payment of a lump sum or a series...
, to describe a negative impact that is experienced when an annuity purchase is delayed on a fund from which regular withdrawals are being taken by an individual. It is the increasing risk of falling annuity rates, and grows exponentially as an individual continues to defer an annuity purchase. In practical terms it represents the extra investment return a customer has to achieve to justify not annuitising a pension fund.
How a lifetime annuity works
In simple terms, a lump sum is given to an insuranceInsurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
company that agrees to pay a regular payment over the expected lifetime of an individual. This payment may be based on interest rates or returns on investments, and will take into consideration costs (and profits). It may be helpful to think of it as a loan in reverse, from the perspective of the individual purchasing the annuity. Those who live longer than the mean
Mean
In statistics, mean has two related meanings:* the arithmetic mean .* the expected value of a random variable, which is also called the population mean....
lifespan of an annuity population are effectively subsidised by those who die earlier and the insurance company usually assumes the risk of making this work based on actuarial
Actuary
An actuary is a business professional who deals with the financial impact of risk and uncertainty. Actuaries provide expert assessments of financial security systems, with a focus on their complexity, their mathematics, and their mechanisms ....
assumptions. This is known as a "cross subsidy". An individual may therefore suffer a "mortality loss" or "mortality gain" based on when they actually die. This is a risk they take on board in exchange for a guaranteed income for the rest of their (uncertain) lives.
Delaying an annuity
When an individual delays buying an annuity, say between the ages of 60 and 65, the following will occur:- Some of the population who purchased an annuity at the age of 60 will have died, meaning their subsidy has been lost to those purchasing at 65.
- While the total expected remaining lifespan will have decreased, the mean age of death in an annuity population entering at age 65 will be greater than for a group purchasing at age 60.
In practical terms, those who invested instead of purchasing an annuity may gain more from the growth of the investment than they lose in the delayed annuity rate. However, where an individual decides to take withdrawals from a given lump sum before buying an annuity, the impact of mortality drag becomes very significant and increases exponentially with age.
For example, using imaginary actuarial assumptions, an individual with $100,000 could buy an annuity with an underlying interest rate after costs of 5% that would give them $8,024 at the end of each year based on a mean
Mean
In statistics, mean has two related meanings:* the arithmetic mean .* the expected value of a random variable, which is also called the population mean....
life expectancy of 20 years. Instead, they invest in an investment with a fixed return of 5% and take $8,024 at the end of each year. Three years later they use the residual investment, now worth $90,466, to buy an annuity. The mean remaining life expectancy according to the mortality tables used by the insurance company will not be 17 years but longer. Let us suppose it is 18 years. The annuity that can now be purchased would give $7,739 each year. In order to offset the reduction, the alternative investment used for three years would have had to return 5.47%. If an individual waits longer than three years, the additional growth required will increase over time, reflecting the exponential effect of mortality drag.
The option of deferral
In the United KingdomUnited Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
an Unsecured Pension (USP), still popularly referred to as income drawdown, permits an individual to make withdrawals from a private pension fund from a permitted age before buying an annuity. The maximum level of withdrawal is controlled, but care must also be taken to maintain the fund at a level that can still buy an equivalent or better annuity in the future. The risk of reduced general annuity rates in the future must be considered and mortality drag increases exponentially as a person gets older.