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.
Annuities are based on the principle of mortality cross subsidy, and while this is good for those in good health and stand a good chance of beating the bet with the actuaries, they are not such a good bet for those in poor health. To solve this problem, insurance companies offer enhanced annuities which pay out a higher income for those in poor health.
Those who smoke, take prescription medication or have been in hospital recently may be able to qualify for an enhanced annuity.
I believe there is a strong case for annuities and that they will continue to play an important role in retirement income planning. Although everybody will be free to take their pension as a cash lump sum or regular income payments, many people will recognise the advantages of securing a guaranteed income and use some or all of their pension pot to purchase an annuity.
Looking to the future, I predict three important trends:
1 New product developments and annuity buyback;
2 More sophisticated use of annuities in retirement income planning;
3 Better understanding of the behavioural aspects of decision-making.
Insurance companies can now increase the length of the guarantee period on annuities.The maximum guarantee period in the past was 10 years but will be extended by some insurance companies to 20, or even 30 years. This, together with more favourable taxation of the value protection benefit will help those who are concerned about dying and leaving their dependants short of income.
There is now an interest in deferred annuities. For example, someone could purchase an annuity at, say, 60 which would not come into payment until he reached the age of 85. At first this might seem like dead money, but if his 85th birthday was reached the income would be guaranteed for the rest of his life. This could be a very useful addition to a drawdown plan because it would provide insurance against running out of income in later life.
The final piece of the annuity jigsaw came in the March 2015 Budget when details were announced of plans to allow people to convert existing annuities in payment into a cash sum. The proposal is to allow people to assign the income from an annuity to a third party who will pay a cash sum either directly to the policyholder or into another pension plan. Tax will be paid at the recipient’s marginal rate when cash is paid out. The intention is that the so-called annuity buyback option will be available after April 2016, and this means that those who purchased an annuity in the past will be able to take advantage of the new pension freedoms.
