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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.[not in citation given]
How a lifetime annuity works
In simple terms, a lump sum is given to an insurance 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.
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 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. In this example, if the person only gets 5% return each year and then buys the annuity, he is worse off than if he had bought it immediately. But on the other hand, if he dies during the three years, he leaves to his heirs most of the $100,000, whereas if he had bought the annuity he wouldn't leave them any of it. So buying the annuity immediately is a way of betting that he will survive the three years, whereas delaying the purchase is a way of betting that he will die during the three years (or that he will get more than 5% return during them).
The option of deferral
In the United Kingdom 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.
- Richards, Stephen; Jones, Gavin (2004), Financial aspects of longevity risk, section 5.4, p. 12