Annuities pay income for life and drawdown has a lump sum death benefit

One of the main attractions of drawdown is that if the policholder dies before the age of 75 any remaining fund can be paid to the family less 35% tax, whereas with an annuity the capital is lost on death.

The comparison between drawdown and annuities is more complex than it seems because there is an invisible force at work called mortality drag.

When you buy an annuity you benefit from a mortality cross subsidy but this is not present in drawdown and the effect is known as mortality drag.

Mortality cross subsidy

Annuities are based on the principle of mortality cross subsidy where those who die before their normal life expectancy subsidise those who live longer than expected.

Drawdown results in the deferral of annuity purchase and so the investor does not benefit from the mortality cross subsidy.

This means that in order for a drawdown fund to provide the same income as an annuity there has to be an extra investment return each year to compensate for the absence of this subsidy.

The effect of mortality drag

The chart below shows the investment growth required year on year in order that the drawdown could purchase the same level of annuity income.

The chart shows that the older you are the greater the impact of mortality drag and means that the risk of drawdown increases with age. This is often used to justify the concept of "phased annuities" where segments of drawdown are converting into annuities at regular intervals in oder to reduce the effects of mortality drag.