Mortality cross subsidy
When you purchase an annuity, the insurance company works out your life expectancy and calculates the amount of your annuity payments. However you may not live to your calculated life expectancy and if you die earlier the insurance company will make a profit from you. However you may live past your normal life expectancy in which case the insurance company will make a loss on your annuity.
The annuity company uses any profit made from you to pay the pensions of others who live longer than expected but you may benefit from those who die early if you longer than expected.
This means that those who die before their normal life expectancy subsidises those who live longer than expected and this is called Mortality cross subsidy.
When drawdown was first introduced, a well-known actuary pointed out that comparing annuities with drawdown was not comparing like with like because annuities benefit from mortality cross subsidy whereas with drawdown there is no cross subsidy.
Therefore comparing annuities with drawdown is not straightforward but it is essential to have a way of comparing them especially as many drawdown policies may not be for life and may be used to purchase an annuity at a future date.
Mortality drag – the invisible force
If an annuity purchase is deferred, the annuity payable at a future date will be higher because of the policyholder's increase in age, but an invisible force slows down this rate of increase, called mortality drag. This is described as the negative effect of missing out on mortality cross subsidy if an annuity is deferred.
The practical relevance of mortality drag is that a pension drawdown fund has to increase in value by an additional amount to compensate for the lack of mortality cross subsidy if it is to maintain its ability to buy an annuity paying the same income in the future.
Mortality drag for standard annuities
Mortality drag for enhanced annuities
The reason why the graph is steeper is bacause enhanced annuities pay a higher income and consequently the rate of return from year to year is higher
William Burrows - taken from The Case for Annuities