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Mortality risk: the threat to DC members

Mortality risk: the threat to DC members

More people are opting for the drawdown of their pension over buying an annuity. However, the downside of that is retirees from defined contribution (DC) pension schemes are now taking on whole new areas of risk to which they haven’t previously been exposed - including inflation/investment risk and mortality risk.

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Mortality risk: The threat to DC schemes - illustration of a man walking on a rope

Members can, of course, take advice and do their own research to manage their drawdown investments, reducing the possibility of inflation eating away at the value of a pension pot, even after investment returns. The problem is that mortality risk cannot be dealt with in the same way. Once you’ve retired, how can you effectively manage the risk of your DC pot running out before you (expect to) die, without locking into an annuity? Mortality risk therefore represents the biggest threat to wiping out a DC pension outright.

Where we are now

The days of gold plated private-sector defined benefit (DB) schemes are numbered. Membership of DC schemes are now a staggering 26% higher than membership of DB schemes. From now on, retirees will be faced with choices and risks they have not previously had to manage, if they choose not to take an annuity. 

When a DC scheme member reaches retirement, their pot of money will, in the absence of other benefits, need to last for potentially over 20 years – a significant period of time. Many of us are comfortable with some degree of risk in terms of our investments – but that risk becomes far more critical, if your living standards as a pensioner are effectively on the line.

The table below shows, in broad terms, who shoulders responsibility for two of the key at-retirement risks in pension schemes. 

    Inflation / Investment risk      Mortality risk                     
DB Scheme        Employer Employer
DC Scheme* Member  Member 

* assuming an annuity isn’t bought with the DC pot at-retirement. 

The difference is stark: in a DC scheme, the risks at (and sometimes in) retirement rest solely with the member, particularly for those people who choose to use drawdown at-retirement, instead of purchasing an annuity. Of the two risks above, mortality is far more difficult to assess. It’s the elephant in the room: everyone knows it’s there but, but many still tend to ignore it.

What are the challenges?

There are several issues to consider:

  • Should independent financial advisers take a more active role in managing clients’ expectations? Should they, for example, be using a ‘distribution’ of life expectancy to provide their clients with probabilities (e.g. a 95% chance of living to age x, a 50% chance of living to age y and a 5% chance of living to age z) to give members a clearer sense of how long the benefits need to last?
  • When you search online for “what is my life expectancy”, several ‘life expectancy calculator’ options appear. These are based on health characteristics that vary greatly from person to person. Are these calculators oversimplifying a question which is actually hugely complex?
  • Should it be compulsory for part of a member’s DC pot to purchase an annuity and/ or a reintroduction of maximum drawdown limits, in order to ensure that people never completely run out of funds? 

Pension scheme members generally underestimate their life expectancy. How can sponsoring employers and trustees therefore help to ensure that future generations don’t run out of resources?

The three-step approach to tackling mortality risk

  • Proactive governance oversight – Employer Governance Committees and Trustee Boards can actively oversee average pot size progress and member engagement rates and, where appropriate, step in to inform members of the risks they are running with their pension pot.
  • Clear and timely communication – Communications typically step up from age 50 onwards. Yet engagement in DC benefits needs to start earlier to be more effective – such as giving time for more contributions to be paid in and greater potential investment returns. Annual employer or Trustee-driven newsletters could play a big role here, adding a personal touch to the ‘member journey’.
  • Engagement in modelling/ projection tools – The earlier members realise that the projection for their project pot is potentially insufficient, the more time they will have to remedy the situation. 

For further information, please contact Emma Skedgel

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