Mortality drag
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Mortality drag is a term used, in reference to life time 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.
First, it should be understood how a lifetime annuity works. In simple terms, a lump sum is given to an insurance company that agrees to pay back the sum over the expected lifetime of an individual based on a fixed underlying interest rate or the return on underlying investments after costs have been taken into consideration. (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 lives which cannot be pre-determined.
When an individual delays buying an annuity, say between the ages of 60 and 65, the following occur:
- Some of the population that would have been included in an annuity purchased 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 with an invested amount may gain more from the growth of the investment such that they are still better off waiting until they are older to purchase the annuity. 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 the United Kingdom Pension Income Withdrawal (formerly and 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.
