Many people are attracted to drawdown for the death benefits because they
don't like the idea that with an annuity the capital is lost on death. On
the other hand annuities generally provide a higher income than drawdown.
The comparison between drawdown and annuities is more complex than it seems
because there is an invisible force at work which is called "mortality
drag" . When you buy an annuity you benefit from a mortality cross
subsidy. This cross subsidy is not present in drawdown and the effect of
not having this subsidy is called mortality drag.
Mortality cross subsidy
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Mortality drag
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| Annuities are based on the principle
of "mortality cross subsidy". Those who die before their normal life
expectancy subsidise those who live longer than expected. |
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If an annuity is deferred the
investor is missing out on this subsidy. The extra return required to
compensate for the absence of this subsidy is called mortality drag.
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The older you are the greater the impact of mortality drag. In practical terms this means that annuities become more attractive at older ages and consequently the risk of drawdown increase. This factor is often used to justify the concept of "phased annuities", that is converting segments of drawdown into annuities over time because it helps to reduce the mortality drag.
