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Gainful employment

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&#39s benefit. This is where I concluded last week&#39s

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&#39s death, be sufficient to buy an annuity for his

nominated beneficiary.

For the purposes of this article, we will assume the beneficiary to be the

scheme member&#39s 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&#39s 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&#39s 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&#39s age at the date

of the annuitant&#39s 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&#39s 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&#39s 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&#39s 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


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