What are Mortality Credits? How are they relevant to me?
Mortality credits (or sometimes called "mortality gains") are a concept used primarily in the context of annuities, particularly in life annuities or tontines. They represent the portion of the return on an annuity that arises from the pooling of longevity risk among a group of annuitants. In simpler terms, those who die earlier than expected effectively subsidize those who live longer than expected.
Understanding the return on investment (ROI) from mortality credits requires a slightly different lens than typical investment ROI. Here's a breakdown:
Conceptualizing Mortality Credits: When an individual buys a life annuity, they are essentially betting that they will live longer than the insurance company's life expectancy tables predict. If they do, they benefit from mortality credits. If they live shorter than predicted, their unused funds are used to pay benefits for those who live longer.
Measuring Mortality Credits: The actual "return" from mortality credits is a bit abstract. It isn't a direct percentage return like interest from a bond. Instead, it manifests as higher periodic payments from the annuity than if the payments were based solely on interest and principal return without the pooling of longevity risk.
Factors Affecting the Magnitude of Mortality Credits:
Age: Mortality credits typically increase with age. Older annuitants experience higher mortality credits because, in any given cohort of people, as age increases, a larger proportion will pass away, leaving behind their contributions for the remaining group.
Size of the Pool: The stability and predictability of mortality credits depend on the size of the annuity pool. Larger pools tend to have more predictable mortality patterns, which is beneficial for insurance companies offering annuities and, indirectly, for the annuitants as well.
Interest Rates: Mortality credits can be thought of as an additional "return" on top of the interest rate return of the underlying investments of the annuity. When interest rates are low, the relative importance of mortality credits in the total annuity payment may rise.
Calculating ROI with Mortality Credits: A precise ROI incorporating mortality credits would involve forecasting an individual's life expectancy, determining the present value of all future expected payments based on that life expectancy, and comparing it to the initial investment in the annuity. Mortality credits would effectively boost the ROI for those who live longer than expected and reduce it for those who live shorter. However, remember that this measure is probabilistic — actual results will vary based on someone’s actual longevity.
In conclusion, mortality credits provide an essential boost to the returns on annuities for those who live longer than average, representing the redistribution of assets from those who passed away earlier. When considering an annuity as an investment, potential annuitants should understand how mortality credits may influence their total returns, especially in the context of their expectations about their own longevity.