Mortality Drag

One of the risks of the drawdown pension option is known as mortality drag.

Mortality drag is defined as the loss of the mortality gain that applies to a policyholder who purchases an annuity.

Mortality gain works as follows:

• when individuals purchase annuities all of the funds are invested together by the insurance company;
• some of the annuitants will die earlier than expected, meaning the provider will have to pay out less annuity income than they were expecting;
• these extra funds remain invested and the extra amount is known as the mortality gain to the fund; and
• the insurance company will use the mortality gain to slightly enhance the rate they offer to individuals who buy an annuity (also known as ‘cross subsidy’).

The mortality drag is therefore the extra return required from the pension fund investments to offset the loss of the cross subsidy that exists within an annuity.

With drawdown there is no cross subsidy.

Investment risk

Investment risk exists because the pension fund remains invested. This means that the value of the fund can go down as well as up.

Charges

Drawdown requires ongoing reviews and investment advice. Consequently, the level of charges will be higher than the charges associated with an annuity. Fixed charges will have a great impact on a small pension pot.

Annuity risk

An ‘advantage’ of a drawdown pension is that annuity rates increase with age and, therefore, that annuity rates may increase during the deferral period. While this is the case, it could be that the underlying annuity rate is falling.

Depletion of the fund

There is a chance that the fund will be depleted if the member takes a high income from the pension which the issue can be made sores if investment returns are poor.

With the introduction of flexi-access drawdown, there is a very real danger than individuals can ‘live too long’ and exhaust the funds in their drawdown pension before they die.