Last week, I started to look at a number of key issues which support
pension drawdown as a legitimate candidate for a much greater share of the
retirement income option market, despite its potential disadvantages.
I started to describe and compare the concept of mortality gain against
mortality drag, noting that the former is particularly relevant to clients
who would ordinarily have bought a joint-life conventional annuity whereas
the latter relates in its severest form to clients who would choose to buy
a single-life annuity.
If we take into account the value of the death benefits inherent in the
drawdown contract – in contrast to the fact that these have to be “bought”
in a conventional annuity by a reduction in income for the annuitant – we
can identify a reduction in the impact of mortality drag but not an actual
Even after taking into account these death benefit issues, the drawdown
investment portfolio is still shown to require a higher rate of annual
investment growth than the prevailing redemption yield on long-dated gilts.
Thus, so far, what our regulators appear to have termed mortality gain is
in fact only a reduction in mortality drag.
However, that overall result is arrived at by broadly equating the death
benefit under drawdown with a conventional joint-life annuity with a 100
per cent surviving spouse's benefit. This is where I concluded last week's
article, suggesting that such a comparison is unfair and misleading.
Leaving aside issues relating to investment performance and annuity rates,
we can consider the death benefit under drawdown as being available to buy
an annuity for the nominated beneficiary. Subject to the value of the fund
holding up and annuity rates remaining broadly unchanged, the drawdown fund
will, on the scheme member's death, be sufficient to buy an annuity for his
For the purposes of this article, we will assume the beneficiary to be the
scheme member's spouse. This annuity can be compared with the annuity which
would have been payable to the surviving spouse from a joint-life
conventional annuity. Or can it?
Take, for example, a couple, both aged 65, buying a joint-life (100 per
cent spouse's benefit) conventional annuity. This would yield an income of
around £7,000 a year, this figure being around 20 per cent less than
the equivalent single-life rate of around £9,000 a year.
What type of annuity would the spouse be left with in the event of the
death of the main annuitant, say, at age 70? You might answer £7,000
(correctly, to some extent) but the question asks what type of annuity. The
correct answer is:
a: A single-life annuity, that is, the annuity payments come to an end on
the death of that surviving spouse;
b: Payable at joint-life rates, that is, £7,000 a year rather than
£9,000 a year; and
c: payable at rates applicable when the annuity was first entered into,
that is, at age 65 rather than age 70, as at the date of death.
These three aspects of the survivor's annuity – single-life annuity at
joint-life rates, applicable to their age at outset – should now be
compared with the type of annuity that a surviving spouse could purchase if
left with the fund from a drawdown contract.
Here, on the death of the pension scheme member, subject to the fund
remaining more or less at the same level as at outset (net of investment
gains and annual withdrawals), the annuity which could be purchased by the
surviving spouse would be:
a: A single-life annuity, as with the conventional annuity comparison; but
b: At single-life rates, meaning that, rather than £7,000 a year, an
annuity of £9,000 a year would be payable; and
c: This annuity to be bought appropriate to the survivor's age at the date
of the annuitant's death (aged 70) rather than their ages at outset (65).
This latter consideration would push the equivalent single-life annuity up
from the assumed £9,000 a year for a 65-year-old to around
£10,500 a year for a 70-year-old and would generate an even more
pronounced enhancement if an earlier annuity purchase date or later date of
death had been assumed in the example.
In total, against a spouse's pension of around £7,000 a year from the
conventional annuity, an annuity of £10,500 a year could be bought
from the drawdown fund. This clearly indicates, to my view, that the
drawdown death benefits in this respect represent much better value even
than a 100 per cent joint-life conventional annuity.
This consideration could be actuarially quantified. My “back of a fag
packet” calculations indicate that, when this benefit is taken into account
and added to our earlier considerations, there is such a thing as mortality
gain which, therefore, is not simply a reduction in mortality drag.
To further emphasis this view, I would like to lead towards conclusion of
this article by following through the above argument about “What is left if
the annuitant dies?” to ” What is left if the annuitant's spouse dies?” and
then to “What is left if both die?”
To continue our above example, in a 100 per cent joint-life annuity, what
type of annuity is left if the named spouse predeceases the annuitant, let
us say at age 70? I am looking particularly at the definition of spouse
being the named spouse or the spouse at date of retirement, whichever
terminology you prefer.
The annuitant is then left with a single-life annuity payable at
joint-life rates determined at the outset of the annuity purchase. In other
words, exactly the same advantages for drawdown can be identified as in the
previous example. Most important, neither of these two advantages are taken
into account in the calculation for the critical yield and so should be
noted separately in discussions and recommendations to the client.
Finally, what if both the annuitant and the spouse die while in the
drawdown period before age 75? In this case, the joint-life conventional
annuity will cease altogether, leaving the accumulated pension fund
valueless, while under drawdown the full value of the fund remains, albeit
subject to the special tax.
In summary, I am afraid to say, one of the most significant benefits with
drawdown often goes unrecognised by both the adviser and his client – the
additional death benefit (even over 100 per cent joint-life annuities) on
the deaths of either the annuitant, the spouse or, particularly, both
spouses before age 75.
An understanding of annuity tables to give the client some idea of the
statistical chance of these eventualities might help but, even without this
fine-tuning, these concepts are vital to the client's decision and the
consequent chances of a preference being made in favour of drawdown.
However, all this presupposes that the client is prepared to accept the
other major risks of drawdown – investment and interest rate risk – and so
next week we will look closer at these risks and how to minimise them.
Keith Popplewell is managing director of Professional Briefing