Annuities Explained Mortality Cross Subsidy & Mortality Drag


Mortality Cross Subsidy & Mortality Drag – What is it?

Lifetime annuities provide people with an income for life because the funds that are not used up from the people that die, help to pay for the annuities of people that live on. Therefore this process is called mortality cross subsidiary.

Before you buy an annuity, an insurance company will calculate your life expectancy, otherwise known as your ‘mortality rate.’ They use this as the main factor when calculating the annuity payments that they are prepared to offer you. People who live much longer than expected would benefit from prolonged income instalments.  The older a client becomes, the higher the cross subsidy will be, so the investment return for that person will be even higher.

Longer Delay

The longer you delay your annuity purchase, the less you will benefit from the cross subsidy when you eventually buy an annuity. Therefore this is what people refer to as ‘the annuity drag’. Annuity providers will look at current death rates and longevity before setting their annual annuity rates. It is important to remember this when delaying setting up an annuity fund, as even delaying for a year could result in you potentially losing quite a large amount of money that you could have gained if you had started the fund earlier, thus missing out on the mortality cross subsidy.

Some people opt to wait as long as possible before purchasing an annuity, instead drawing an income from their pension fund whilst leaving the money invested. The main attraction of this type of drawdown fund is that if the policy holder dies before the age of 75, the remaining funds can be paid to the family, though with 35% less tax. This contrasts with the annuity capital where the capital is lost on death.

Greater Impact

Previous research has shown that the older you are, the greater the impacts of mortality drag, meaning that the risk of drawdown does indeed increase with age. This term is often used to justify the concept of phased annuities, where segments of drawdown are converted into annuities at regular intervals in order to reduce the effects of the ‘mortality drag’.

The term ‘mortality drag’ describes the negative impact that is experienced when an annuity purchase is delayed on a fund from which regular withdrawals are being taken by an individual. This drag varies with age and is taken into account when calculating the critical yield, or the annuity rate. Fewer people buy annuities at older ages, so there are less of them to subsidise each other.

It is something to keep in mind and potentially something to discuss with an IFA when planning your annuity options.

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