Advisers must explain how ‘mortality drag’ means funds in drawdown must produce increasingly higher returns to match an annuity, a report claims.
The paper, written by Retirement Intelligence director Billy Burrows for Partnership, warns that the “invisible force” of mortality drag means drawdown becomes less attractive relative to an annuity as a customer ages.
Mortality drag is the idea that someone deferring buying an annuity is missing out on mortality cross subsidy. Annuity policyholders benefit from the pooling of longevity risk when people die younger than the insurance company expects.
The report says: “The required fund growth and mortality drag increases each year and this reflects the need to compensate for mortality drag. If we repeat these calculations using enhanced annuity rates we will see that not only is the income taken higher, but the required investment returns and mortality drag is higher.”
Since the 2014 Budget the number of annuities sold has plummeted, while more people are entering drawdown contracts.
However, the report says annuities are the only policy that “can pay a high level of guaranteed income for life”.
It warns: “An annuity is a pension, and in the rush to give people more choice it is easy to lose sight of why people save for a pension.”
The report also compares annuities to mortgages, to show that the policies do represent value for money, despite the poor reputation they have acquired over the last few years.
It says the repayments for a 23 year mortgage are nearly the same as the payments made to a 65-year-old buying an annuity who lives for a further 23 years.
But is says annuities’ value for money has reduced “by a relatively small amount” because of increasing life expectancy, the impact of enhanced annuity sales on mortality cross subsidy, and more onerous capital requirements for providers under Solvency II.
Burrows says: “The important message for adviser is though there are freedoms, there is still a strong case for annuities as well as for drawdown. They must properly explain to their clients the advantages of both.
“For any client there are three important questions: what are their income requirements, what is their need for flexibility, and how much risk are they prepared to take.
“It’s like turning the clock back 10 years when we were having sophisticated discussions about how to use annuities. That dropped away with the advent of shopping around and people focussed on the level of annuity income. Now we’re talking about the quality of the proposition again.”