Mortality drag and critical yield
The very mention of mortality drag is likely to make your eyes glaze over. But if you are serious about considering income drawdown, you do need to pay attention.
The annuity rate that a 65 year old receives is higher than it might otherwise be because it is subsidised. This arises because annuity providers have enhanced the 65 year olds annuity rate by the profits they make from those that die younger than expected. The longer you wait to purchase your annuity, the greater the returns need to be on your pension fund to make up for this subsidy that you have foregone by not buying an annuity earlier – this extra return is “mortality drag”.
For example, looking at the table below, a single male of 60 who puts off annuity purchase until age 75 will require an extra 2.3% per annum of growth just to make up for mortality drag.
Mortality drag: Single male, no guarantee period, no increases
| |
Age at which annuity purchased |
| Age at outset |
60 |
65 |
70 |
75 |
| 50 |
0.5% |
0.8% |
1.2% |
1.6% |
| 55 |
0.7% |
1% |
1.4% |
1.9% |
| 60 |
- |
1.4% |
1.8% |
2.3% |
| 65 |
- |
- |
2.2% |
2.8% |
| 70 |
- |
- |
- |
3.4% |
Mortality drag: Male, female 3 yrs younger, 50% widows, no guarantee period, no increases
| |
Age at which annuity purchased |
| Age at outset |
60 |
65 |
70 |
75 |
| 50 |
0.2% |
0.4% |
0.6% |
0.8% |
| 55 |
0.3% |
0.5% |
0.7% |
1% |
| 60 |
- |
0.7% |
0.9% |
1.2% |
| 70 |
- |
- |
- |
1.5% |
| 75 |
- |
- |
- |
1.8% |
On your illustration for income drawdown there should be a critical yield (in fact there may be two yields quoted, but we won’t get bogged down in that detail here). Generally speaking critical yield is the growth rate required from your income drawdown fund to ensure that the conventional annuity that could have been bought at outset can still be secured at your desired annuity purchase date (usually age 75).
The critical yield takes into account the charges on the income drawdown plan and also mortality drag. The critical yield for our 65 year old considered above, taking maximum income, is 7.4%. Do you believe that this growth rate is achievable in the years immediately ahead? Are you prepared to take the investment risks required to achieve this growth rate? These are matters you will need to consider carefully before proceeding with income drawdown.
The critical yield gives you a feel for how aggressive your investment choice needs to be, and you will need to confident that this is a level of risk with which you are comfortable, as well as it being one you feel is reasonably achievable.
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