Are annuities good value for money?

Mortality – what a drag

To understand ‘mortality drag’, consider – just for illustration – a 70-year-old who (according to mortality tables) has a 1% chance of dying over the next year.

An insurance company can pool many similar lives in terms of estimated future lifespan. If they know that one in every 100 such people will die between 70 and 71, they can reflect that in cheaper annuity rates for everyone at age 70. It’ll be roughly 1% cheaper than delaying for a year because the surviving annuitants effectively get a subsidy, as the pots of the deceased are shared out. 

Someone who delays purchasing an annuity cannot therefore benefit from that subsidy, and this lack of subsidy is called the mortality drag. Of course, a different perspective is that the one 70-year-old who dies out of the 100 would lose money by having purchased annuity, when they could have left it to their spouse or children if they didn’t annuitise.[1] For those less interested in leaving a bequest, for whatever reason, this may not be a concern, however.

Investment strategy

What does the mortality drag mean for investment strategy? Basically, it represents the minimum excess return (over risk-free assets) you need to ‘keep up’ and not wind up with worse spending outcomes than if you’d bought an annuity.

In the illustrative chart below, we show what this drag looks like, and compare it with the excess returns we usually expect on a few different asset classes.

As you can see, mortality drag – the hurdle for investment to keep up with – starts off fairly modest but grows exponentially with age, ultimately exceeding the return you can generate from even the riskiest of asset classes.

There are a couple of ways investors could try to deal with their mortality drag if they want to avoid running out of money in retirement. They could:

• Spend less, i.e. ‘self-insure’ against the risk of outliving your pension pot, which would require increasing prudence in spending with age. This hardly seems like an appealing option! As we’ve shown elsewhere, this can be problematic.

• Take more risk in their investment strategy in an attempt to generate high enough excess returns. The problem, of course, is that even if they could do this, it would introduce greater investment risk.

The alternative, of course, would be to purchase an annuity! Perhaps not such a bad idea after all?

The risks of not purchasing an annuity

This might sound a bit abstract and you might be sceptical of this mortality-drag business. So here is another way to look at the question of whether to purchase an annuity, based on the chance of outliving your money.

Imagine you took the same income as available from an annuity, but used an income-drawdown investment strategy instead. For example, if you’re a 66-year-old with a £100,000 pot, you could buy an annuity that guarantees an income of about £5,000 per year for the rest of your life.

But what if you invested that £100,000 in an income-drawdown fund and took £5,000 a year from that instead? If the chance you outlive your savings turned out to be small (say, less than 5%) then purchasing an annuity might not seem such a good deal. You could safely withdraw the same amount, or possibly more, and have a potentially sizeable bequest to leave behind to boot.

But under some sensible modelling assumptions (given at the end of this blog) the chance of outliving your savings is about 19%, which is far from negligible! And if you repeat the calculation at higher ages, the risks are much higher, as you can see below.

Mind the bequests

All of the above basically assumes your primary objective is an income for life. For some people – millionaires, for example, or those for whom state and other DB pensions dwarf their DC pot – the importance of leaving something behind could be more important. It might even be their primary objective. But perhaps the rest of us should pause for thought before ruling out annuities from our retirement plans.

Modelling assumptions:

• Mortality rates based on ONS data, adjusted for consistency with current annuity rates and gilt discounting
• Income-drawdown strategy assumed to earn a median return of cash plus 2.8% with 8.0% volatility.

[1] In this analysis, we focus on single life annuities with no guarantee. Annuities with guarantees and/or dependant benefits offer different costs and benefits.