As consumers age, their life expectancy does not reduce at the same rate that they are ageing. Because they have survived over a period within which they could have died, their life expectancy increases.
For example, the joint life expectancy for a 65-year old couple today is 24.3 years. But by the time they are 80 (in 15 years’ time), their life expectancy is now 12.1 years, not 9.3 years – an increase of almost three years to their expected age at death.
For a retiree in drawdown, if they withdraw money to last their expected lifetime, then every passing year they have likely overspent and their remaining pot has to go further to meet the additional life they have “gained”. This is called mortality drag.
To make matters worse, this built-in disappointment (if living longer than previously expected can be called that) gathers pace with age. This leads to the retiree becoming increasingly sensitive to changing market conditions and personal circumstances.
Mortality drag can be demonstrated by considering how much a pension drawdown fund must grow for each year that someone defers buying an equivalent annuity.
The graph below shows how the excess return of bond yields required to match an annuity purchase varies with age for someone retiring today at 65:
Figure 1: Mortality drag by age
This simplified graph:
- Assumes that a fixed income is drawn each year, at a rate matching the annuity that could be bought at the outset.
- Calculates how fast the remaining portfolio must grow each year, to be able to buy the same annuity as the retiree ages.
- Assumes the annuity interest rate remains unchanged throughout.
The effect of mortality drag is more resounding when considered against the proportion of the population that is likely to be affected.
The graph below shows this, again for persons retiring at 65:
Figure 2: Mortality drag by survivorship
Three options for your customers to consider
As time goes by, the increasing pace of mortality drag means your customer’s retirement fund must work increasingly hard to support their diminishing portfolio.
We outline three things to consider below;
Option 1
Increase the level of risk in your customer’s pension fund. Although this is typically a time when de-risking would be more appropriate, this could help to meet the shortfall. However, it is important to communicate these challenges to your customer so they are able to make well-informed decisions about any additional risk they are taking on.
Option 2
Your customer may decide to live a progressively more frugal lifestyle by drawing a smaller and smaller income. We recently launched a free-use tool to help individuals see what their lifestyle could look like if they changed their level of income.
Unfortunately, neither of the two options above are guaranteed to work. And both invite disappointment in one form or another.
Option 3
Your customer may wish to consider switching to a form of Annuity Product to get around these issues by taking advantage of mortality cross-subsidy (or mortality credits). This is where retirees living longer than average are subsidised by those who have died earlier.
For a retiree who has chosen to receive their income through drawdown, this luxury is not available. They increasingly carry the risk of outliving their pension pot and running out of money. Because of this, the optimal sustainable income required to avoid disappointment remains elusive. And the drawdown journey needs careful planning and life-long monitoring.
Conclusion
To easily communicate the impact of mortality drag -or any investment risk for that matter - you can provide simple online tools to help educate your customers. That way they can easily understand the different scenarios that might play out - especially in the latter stages of accumulation and early stages of decumulation - with reactive changes they may need to implement in order to keep their retirement plans on track. The importance of giving due consideration to the impact of mortality drag when setting a drawdown strategy cannot be overstated.
So what next?
We have released a new comprehensive white paper that highlights the need for an industry-wide change in attitudes towards retirement income. The Drawdown: The Mirror Image of Accumulation white paper is available to download now and covers a plan that reaches across financial advisers, fund and asset managers, and pension providers.
Please click here to download the retirement drawdown white paper and learn more about producing suitable and sustainable outcomes for consumers.
If you would like to find out more information or have any questions please get in touch via contact@ev.uk.
