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Tables turn on pensioners

Last week, I started to look at key issues affecting the choice of

flexible retirement income options by considering the impact of increasing

longevity on conventional annuities and their more flexible alternatives,

primarily, income drawdown and staggered vesting.

I noted that life expectancy for males in the 10 years up to 1990 had

improved by around three years for a male aged 60 (the improvement for

younger males being even higher) and around two years for females. This

increase broadly continued an improvement which was already evident over

the preceding decades.

Indications from insurance companies are that this increase has continued

since the last published mortality tables. What has all this to do with


Conventional annuities are costed on the basis of three main constituent

factors – underlying assumed interest rates (at which we will look closer

in future weeks), mortality assumptions and charges.

In very simple terms- in fact, a little oversimplified – if the insurance

company actuary assumes that an individual purchasing a lifetime annuity

with a fund of £100,000 is likely to live for five years after

purchase, then the mortality element within the annuity rate quoted will be

£20,000, returning to the annuitant the capital cost of the annuity

over his expected lifetime.

If, on the other hand, the annuitant&#39s life expectancy is 10 years, the

mortality element within the annuity will be only £10,000. If his life

expectancy is 20 years, the mortality element will be £5,000.

These are, of course, exaggerated examples which show clearly that the

life expectancy assumed by a conventional annuity provider can and does

have a significant effect on annuity rates.

More realistic than these simplified examples, the improvement in life

expectancy over each recent decade has, for males, resulted in a reduction

of a little under 10 per cent in the annuity rate, broadly equivalent to a

1 per cent reduction in underlying interest rate assumptions.

If all other factors within the annuity calculation remained equal,

annuity rates would have fallen by a little short of 20 per cent over the

20-year period up to 2000. If this trend of increasing longevity continues,

as is widely expected, then a further reduction of up to 20 per cent might

be expected over the next couple of decades.

Perhaps the key message here is the risk warnings which should or must be

given to clients who are being recommended drawdown or staggered vesting.

Both these flexible retirement income options involve the client in

deferral of annuity purchase until typically 75.

If life expectancy continues to improve during this period of deferral,

then annuity rates can be expected to continue to fall, irrespective of

what happens to underlying interest rates. This fall could be significant.

If life expectancy continues to improve at the same rate as in recent

decades, then deferring buying an annuity for 15 years from retirement at

60 to 75 might lead to anything up to a 15 per cent reduction in annuity


But it is my experience that few IFAs have included this risk warning in

their recommendations.

It is vital that the potential impact of increasing life expectancy is

given just as much prominence in the risk warning as the possible impact of

falling interest rates.

It should be noted that our text books advise us, or infer, that annuity

rates are based on historical mortality tables. But, increasingly, such an

assumption has been overtaken by actuarial consideration not of past life

expectancy (as shown by these mortality tables) but future life expectancy.

To use another simplified example, mortality tables compiled in respect of

experience up to 1990 might show life expectancy for a 60-year-old as

being, say, 24 years. Such expectancy does not show true expectancy as it

is based on historical data. If, at that time, continuing improvement in

life expectancy could have been predicted (which, in fact, it commonly was)

then we could envisage the following scenario.

Looking at the last published mortality tables, we might consider that a

60-year-old male can expect to live a further 24 years to age 84.

However, these tables are already out of date and more recent, although

unpublished, figures for this person indicate a life expectancy of 27 years.

Yet even this higher figure is based on past mortality experience and

takes no account of the general consensus of continuing improvement. Over

the next decade, if longevity continues to improve, then our client, at 70,

might now be advised that he is expected to live a further 19 years against

the 16 years indicated 10 years earlier for a 70-year-old.

Then, over the next decade and having reached the age of 80, he is advised

that he is expected to live a further 10 years against the eight years

indicated 10 years earlier for an 80-year-old and so on.

The above example is designed to show that an individual&#39s predictive life

exp- ectancy is, if we assume continuing increases in longevity, much

higher than his life expectancy apparently indicated by mortality tables.

Annuity providers know this, of course, and to my certain knowledge some

of them have already based their annuity rates on the assumption of life

expectancy considerably higher than the PA90 tables, thereby factoring in

some allowance for improved longevity.

The problem remains that deferring buying an annuity is a dangerous

decision and, without doubt, one which should be taken by a client only

after having learned the impact on annuity rates of continuing improvements

to life expectancy relative to those already anticipated by annuity


This issue has already been highlighted in regulatory guidance notes over

the last few years but perhaps could or should have been brought more

strongly to our attention, perhaps including it as one of the major risk

factors in drawdown and staggered vesting recom-mendations, along with the

possibility of falling interest rates and poor investment performance.

If all this sounds more than a little negative as regards the attractions

of flexible retirement income options, then to some extent my apologies.

Readers who have attended any of my seminars will be aware that I am a keen

supporter of drawdown and staggered vesting (and, of course, combinations

of these) but we have to acknowledge and bring clients&#39 attention to risks

in such recommendations.

If we do not, and the client suffers loss as a result of one of these

risks materialising, then we have on our hands a whole new pension transfer

review scenario as, indeed, has already been predicted in some quarters.

Now, with this key issue already discussed, what are the remaining

attractions of flexible retirement income options which can or could still

make them arecommended alternative to conventional annuity options?

Over the next few weeks, I do not want to cover issues which are already

well understood, such as flexibility of income and the level of death

benefits payable from such arrangements. Instead, I want to concentrate on

issues which are perhaps much less appreciated, starting next week with

issues relating to mortality gain, mortality drag and the nomination of

beneficiaries for death benefits.

Keith Popplewell is managing director of Professional Briefing


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