Dear Wizard Learner

Each month in our online CPD in addition to updates on 8 subject areas we also focus on a key topic. This month's we cover critical yield and income withdrawal as detailed below.

Critical yield and income withdrawal
1) Mortality drag
2) Critical yield
3) FSA guidance
4) Investment issues

1) Mortality drag
In this section, we explain the fundamentals of mortality drag and its effect on individuals choosing to take the unsecured pension route.

The cost of any lifetime annuity is based on the average life expectancy of the annuitant. This means that those annuitants who die earlier than expected subsidise those who live longer than expected. An individual using income withdrawal does not benefit from this mortality subsidy inherent in annuity products.

For example, a woman purchasing an annuity at age 60 has about an 85% probability of living to age 75. The annuity rate offered to this woman will reflect the fact that, on average, 15% of similar annuitants will die before 75. The same woman buying her annuity at age 75 will not benefit from this 15% mortality subsidy.

The effect of this lost mortality subsidy for each year in income withdrawal is known as “mortality drag”. As life expectancy decreases with age, the effect of mortality drag increases with age. Therefore those using income withdrawal, need additional investment return to counteract the effects of mortality drag, and the additional return needed each year increases with age.

2) Critical yield
In this section, we explain what the critical yield calculation tries to show and the assumptions it makes.

The critical yield calculation is an attempt to show the investment return needed from an income withdrawal fund to provide a given level of future income.

As well as taking account of the effects of mortality drag, the critical yield calculation allows for the charges associated with income withdrawal.

However, the calculation assumes that interest rates and mortality rates will not change. Both of these crucial assumptions can be held up to challenge based on scrutiny of past experience, where interest rates have fluctuated greatly and mortality has steadily improved. This means it is dangerous to base decisions on critical yields in isolation.

Make sure you are aware of important key financial news and improve your CPD
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3) FSA guidance
In this section, we describe the bases on which the FSA allows critical yield calculations to be made and its concerns regarding the sale of income withdrawal products.

4) Investment issues
In this section, we discuss the investment considerations that those pursuing income withdrawal need to make as well as other reasons why the decision to pursue income withdrawal is the chosen route for some.

Kind regards

Mike Goldsmith FPFS
Chartered Financial Planner

Wizard Learning
www.wizardlearning.com

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