View more on these topics

Drawdown customers risk losing out from ‘mortality drag’, report warns

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.”

Newsletter

News and expert analysis straight to your inbox

Sign up

Comments

There are 12 comments at the moment, we would love to hear your opinion too.

  1. All this presupposes that advisers have their clients’ interests as the top priority. In my experience that is very often not the case with disastrous consequences for the mugs who trust them. Then ‘caveat emptor’ is dredged up.

  2. Plus, with an annuity (no unit-linked) the insurer shoulders the investment performance risk, unlike the drawdown/SIPP gambler’s solution.

  3. You can download a copy of my paper, the case for annuities at http://www.retirement-intel.co.uk/

  4. There are lots of risks in drawdown – reverse pound-cost averaging, sequencing risk and the rest. And annuities are wonderful as insurance policies against living too long. Deferred annuities have strong theoretical advantages but seem to gain little traction even in markets like the US where they are available.
    But it would be worth remembering that while returns for annuities are boosted by mortality drag – the cross-subsidy from those who die earlier then average – there are other factors that drag down the returns. There are all those who die later who pull returns the other way. There is the natural and understandable tendency for insurance companies to be cautious about the future when setting the rates for fixed contracts.
    In the past there has been the tendency for life offices to exploit their quasi-monopolistic position with many annuitants as the FCA has pointed out in the past. The increased use of underwriting might also reduce the impact of mortality drag to some extent.

  5. Splendid paper, Billy. Well worth a read. Have even posted about it on LinkedIn to my (modest) readership. May even contrive to follow up with a tweet, as the points you make I feel are all good ones.

  6. Truth is no particular option for providing retirement income is “The Best”. If you asked all advisers what is the optimum method of receiving retirement income the answer would start with “it depends…”.

    There is also the difficulty in only measuring all retirement income and capital in purely mathematical terms. If accessing a pension in a certain way provides a result that whilst not mathematically the best choice, is best for the preferred lifestyle and well being of the person in front of you, (and the client is fully aware of what other choices are available / advantages / disadvantages) then is this wrong?

    If someone wants to proceed with something which is obviously the wrong choice from a mathematical and sense point of view then your advice should be “I don’t recommend this and will not implement it for you”.

  7. Paul – I agree with your comments. I have always argued that good decisions require consideration of both the technical and emotional issues.

    I go further and say that often there is not a right answer so a combination of annuities and drawdown may provide a better outcome.

  8. Paul, I too agree attention must be paid to both the maths and the real life requirements…the latter being where flexibility comes in. But I have been cheered today by Billy’s demonstration of the maths as it goes a good way to re-dressing the balance of the over-hyped message that annuities are a “bad investment”. Whereas they are more reasonably described as an insurance of a steady income for as long as you live.

  9. A large number of my clients are in drawdown contracts, but MOST of those have been advised to do so as they either have an occupational pension scheme underpinning their retirement income, have opted for an annuity for some of their income, or have a hybrid product with a guarantee built in. Very few could in all good conscience be recommended a drawdown only contract with no guarantee of income other than the state pension in good conscience (IMHO).
    The old flexible drawdown limit at £20k was quite sensible and whilse I thought the “12k limit” last year had gone a bit to far, a joint secure income of £24k could have been argued.
    Just got back from the PFS regional seminar and the risk of misbuying using pension funds to invest in crown funding or peer to peer lending by unsophisticated investors could be huge and there is NO FSCS protection with it. a 10% limit sounds fine in theory, but in practice…….
    Annuities have been slagged off for too much, they serve a valuable PROTECTON service against living too long. They are an insurance contract and NOT an investment contract primarily and were not designed to provide income for 30 years, just secure income for 5-10 years after retirement. The Mineworkers pension scheme kicked in at 65, but most were dead by 70…….

  10. A genuine comparison with drawdown would have helped. Showing drawdown income generated by annuity interest rates is not a fair comparison when most DD funds have much higher equity backing.

  11. Thanks Colin – This is my next project

    I am working on an even handed comparison between annuities and drawdown – without prejudging the outcome, it will all rest on the assumptions made

    At one level it is simple – the returns from drawdown have to be higher than the annuity interest plus a margin for mortality drag and charges

    This is easy to model but what is harder to model is the sequence of returns in the future

  12. How about using the low/mid/high FCA pension projection and low/mid/high FCA annuity rates with current expected future lifespan at various ages?

Leave a comment