Mortality credits: Meaning, Criticisms & Real-World Uses

What Is Mortality Credits?

Mortality credits refer to the additional return or benefit generated within certain financial products, primarily annuities, due to the pooling of longevity risk among a group of participants. In essence, these credits arise from the forfeiture of funds by individuals who die earlier than their statistical life expectancy, with those forfeited funds being redistributed among the surviving participants in the pool⁹⁴, ⁹⁵, ⁹⁶. This unique characteristic positions mortality credits as a core concept in actuarial science and retirement planning, enabling higher lifetime income payouts than individuals could achieve through self-funding alone⁹², ⁹³.

History and Origin

The fundamental concept behind mortality credits can be traced back to the ancient Roman Empire, where the "annua" involved citizens making a lump sum payment in exchange for a lifetime stream of annual income⁸⁹, ⁹⁰, ⁹¹. Early forms of annuities and tontines, which also involved pooling funds, leveraged the principle that those who died early would contribute to the payouts of those who lived longer⁸⁶, ⁸⁷, ⁸⁸.

The term "mortality credit" itself was popularized more recently in academic literature, notably by Moshe Milevsky⁸⁴, ⁸⁵. Its recognition highlights the distinct financial advantage annuities offer through the mechanism of risk pooling. While annuities have evolved significantly over centuries, particularly gaining traction in the U.S. after the 1929 stock market crash and the institutionalization of guaranteed income through the Social Security Act of 1935, the underlying principle of mortality credits has remained a cornerstone of their value proposition⁸¹, ⁸², ⁸³. Research from institutions like the National Bureau of Economic Research (NBER) has extensively explored the role of mortality risk and its pooling in annuity products, analyzing their historical development and implications for retirement income⁷⁸, ⁷⁹, ⁸⁰.

Key Takeaways

Mortality credits enable higher potential income payouts from annuities by reallocating the unused principal of those who die early to those who live longer⁷⁵, ⁷⁶, ⁷⁷.
This mechanism relies on the statistical predictability of mortality rates across a large group, even though individual lifespans are uncertain⁷³, ⁷⁴.
The value of mortality credits tends to increase with the age of the annuitant, as the probability of survival for a given year decreases⁷¹, ⁷².
Mortality credits are a unique benefit of pooled lifetime income products, distinguishing them from individual investment strategies like bond ladders ⁷⁰.
Accessing mortality credits can allow retirees to sustain a higher income stream throughout their lives, reducing the worry of outliving savings⁶⁸, ⁶⁹.

Formula and Calculation

The calculation of mortality credits is embedded in the actuarial pricing of annuities. While there isn't a simple universal formula for a "mortality credit" as a standalone value, its impact can be understood through the difference in potential lifetime income with and without risk pooling.

Actuaries use mortality tables, such as those published by the Social Security Administration (SSA), which provide probabilities of death at various ages for a given population⁶⁴, ⁶⁵, ⁶⁶, ⁶⁷. The value of mortality credits for an annuity owner is effectively the additional return beyond what their principal would generate through investment returns alone, derived from the pool of funds of those who predecease them⁶², ⁶³.

Conceptually, the mortality-adjusted return (MAR) at a given age ( x ) can be considered:

\text{MAR}_x = \frac{1 + \text{Investment Return}}{P_x} - 1

Where:

( \text{Investment Return} ) = The underlying investment return of the annuity pool.
( P_x ) = The probability of an individual aged ( x ) surviving for one more year. This is derived from actuarial life tables⁶¹.

The mortality credit at age ( x ) would then be the difference between (\text{MAR}_x) and the pure (\text{Investment Return})⁶⁰. This demonstrates how the probability of survival directly influences the additional benefit derived.

Interpreting the Mortality Credits

Mortality credits are not a direct payment or a line item on an annuity statement, but rather an implicit enhancement to the regular annuity payments⁵⁹. Their interpretation lies in understanding that they allow for a higher sustainable income stream compared to a self-managed portfolio of the same size and risk profile⁵⁶, ⁵⁷, ⁵⁸.

For an individual, the presence of mortality credits means that the monthly or annual payout received from a lifetime annuity is greater than what they could prudently withdraw from their own savings if they had to account for the risk of living to an exceptionally old age⁵⁴, ⁵⁵. This is because the annuity provider, typically an insurance company, can statistically rely on a portion of the pooled assets becoming available from those who pass away earlier than expected⁵³. The higher the age at which income payments begin, generally the greater the impact of mortality credits on the payout, as the probability of early mortality within the pool increases with age⁵².

Hypothetical Example

Consider a group of 1,000 retirees, all age 65, who decide to pool $100,000 each into a collective fund to provide themselves with a lifetime income. Without pooling, if each person managed their own $100,000 and wanted to ensure it lasted to age 100, they would need to take very conservative withdrawals.

With a pooled annuity fund, based on life expectancy tables, the insurance company knows that a certain percentage of these individuals will likely pass away each year⁵¹. For instance, if 5% of the group passes away in a given year, their remaining principal contributions (or a portion thereof, depending on contract terms) are effectively reallocated to increase the payments for the 95% who are still alive.

If, after a few years, 200 members of the original 1,000 have passed away, their contributions, which are no longer needed to pay them, enhance the income for the remaining 800 survivors. This allows each surviving annuitant to receive a higher regular payment than if they were relying solely on the returns from their original individual $100,000 investment. This additional income, beyond what pure investment returns would generate, is the essence of the mortality credit⁴⁸, ⁴⁹, ⁵⁰.

Practical Applications

Mortality credits are a cornerstone in the functionality and appeal of certain annuity products, particularly those designed to provide lifetime income.

Enhancing Retirement Income: For individuals concerned about outliving their savings, particularly in a low-interest-rate environment, annuities leverage mortality credits to provide a higher guaranteed income stream than could be achieved by self-investing⁴⁵, ⁴⁶, ⁴⁷. This allows for a more confident and potentially higher spending level throughout retirement⁴⁴.
Mitigating Longevity Risk: By pooling resources, annuities transfer the individual risk of living longer than expected (longevity risk) to an insurance company or a group of annuitants⁴², ⁴³. The mortality credits are the financial benefit received by survivors for participating in this risk transfer⁴¹.
Pricing of Annuity Products: Actuaries incorporate expected mortality experience, which gives rise to mortality credits, when determining the payouts and pricing of immediate and deferred annuities. The more accurately an insurer can predict aggregate mortality, the more efficiently they can price these products and offer competitive payouts³⁹, ⁴⁰. The Social Security Administration's (SSA) Period Life Table is a key resource used to assess the actuarial soundness of annuities³⁸.
Comparison to Other Retirement Vehicles: Mortality credits are a key differentiator for annuities when compared to traditional investment portfolios or bond ladders, as this "return" source is unique to pooling arrangements³⁶, ³⁷.

Limitations and Criticisms

While mortality credits offer a significant advantage, particularly in managing longevity risk, they come with certain limitations and are subject to criticism:

Illiquidity: To benefit from mortality credits, an annuitant typically gives up control of the principal amount used to purchase the annuity. This lack of liquidity means the funds are generally inaccessible for unexpected expenses or emergencies³⁵.
No Legacy: A primary concern for some individuals is that if they die early, the unused portion of their principal, which contributes to mortality credits for other survivors, is typically forfeited and cannot be passed on to heirs³⁴. This contrasts with traditional investment portfolios where remaining assets can be bequeathed. However, some annuity products offer riders like death benefits or guaranteed minimum accumulation benefits (GMABs) that mitigate this to some extent, though often at the cost of reduced payouts³³.
Adverse Selection: There is an inherent risk that individuals who purchase annuities may, on average, expect to live longer than the general population³¹, ³². This phenomenon, known as adverse selection, can lead insurance companies to price annuities more conservatively, potentially reducing the attractiveness of the mortality credits for the average person²⁹, ³⁰.
Complexity and Fees: Some annuity products can be complex, with various riders and fee structures that can reduce the overall benefit of mortality credits²⁷, ²⁸. Understanding the "money's worth" of an annuity requires careful analysis of its pricing relative to expected payouts²⁵, ²⁶.

Mortality credits vs. Longevity risk

Mortality credits and longevity risk are closely related concepts, but they represent different sides of the same coin within retirement planning. Longevity risk is the financial risk that an individual will live longer than expected and, as a result, outlive their savings²³, ²⁴. It's the uncertainty an individual faces about their own lifespan and the challenge of making savings last for an unknown duration.

Mortality credits, on the other hand, are the benefit that arises from pooling that very longevity risk across a large group of people²⁰, ²¹, ²². When many individuals contribute to an annuity pool, the insurance company can predict, with reasonable accuracy, the aggregate mortality experience of the group, even if individual death dates remain unpredictable¹⁹. The funds from those who die earlier than the group's statistical average are used to subsidize the payments to those who live longer¹⁷, ¹⁸. Thus, while longevity risk is the problem or uncertainty that retirees face, mortality credits are a unique solution offered by pooled products like annuities to mitigate this risk, effectively providing a higher income stream to those who survive¹⁵, ¹⁶. The article "Mortality Credits: Why Immediate Annuities Beat Bond Ladders" on Kitces.com highlights how mortality credits allow annuities to pay out significantly more than an individual bond ladder could¹⁴.

FAQs

What does "mortality credits" mean in simple terms?

Mortality credits are the extra money you can get from an annuity because some people in the shared pool of funds will pass away earlier than expected. Their remaining contributions help pay those who live longer, giving survivors a higher income stream ¹², ¹³.

Are mortality credits guaranteed?

The concept of mortality credits is inherent in the design of lifetime annuities because they rely on the statistical predictability of group mortality. While the individual benefit from this pooling is not a separate guarantee, the increased payout it enables is typically part of the guaranteed lifetime income provided by the annuity contract, backed by the insurance company's financial strength¹⁰, ¹¹.

How do mortality tables relate to mortality credits?

Mortality tables, like those from the Social Security Administration⁸, ⁹, provide statistical data on the probability of death at different ages. Actuaries use these tables to calculate how much income an annuity can pay out, incorporating the effect of mortality credits, which are derived from these probabilities⁶, ⁷.

Why are mortality credits important for retirement?

Mortality credits are crucial for retirement planning because they offer a way to generate a higher, sustainable income stream for life than traditional investments alone, reducing the risk of outliving savings. They are a unique benefit of pooling longevity risk³, ⁴, ⁵.

Can I get mortality credits without buying an annuity?

Generally, no. Mortality credits arise from the risk pooling mechanism inherent in lifetime annuity contracts. While some experimental longevity pooling arrangements are being explored, the traditional and most common way to access mortality credits is through a life annuity offered by an insurance company ¹, ².