As people age, their life expectancy does not reduce at the rate that they are aging. Because they have survived over a period in which they could have died, their expected age at death 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 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 by for each year that someone defers buying an equivalent annuity. Figure 1 shows how the excess return with respect bond yield that is required to match an annuity purchase varies with age for someone retiring today at 65:
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. Figure 2 shows this, again for persons retiring at 65:
The increasing pace of mortality drag with the passage of time means the retirement fund must work increasingly hard on a diminishing portfolio, and it would have to do so by taking on more risk at a time when de-risking would be more appropriate.
Or, the pensioner could resort to a progressively frugal lifestyle by drawing a smaller and smaller income.
Unfortunately, neither of these approaches is guaranteed to work. And both invite disappointment in one form or another.
Annuities get around this issue 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 in 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.