Coincidentally, the FT published two articles this weekend on annuities.

The first, which I won’t dwell on, is by Jo Cumbo and Ian Smith and looks at the increasing amounts of “buy-out” risk being sent overseas (mainly Bermuda) by insurers, looking to gain from “funded reinsurance”. The worry is , that in the rush to grab assets while the buy-out mania is going on, insurance companies are over-stretching and relying on second-rate partners , operating under lax regulations, to take on more business than they can properly digest.

This is as much a consideration for retail investors as for institutional trustees, as it calls into question the “gold-plated” status of the annuity promise and raises concern that insurers are putting shareholder profits over the security of those buying “guaranteed” income for life.

But putting aside questions that were better considered by the PRA and TPR, I move on to my second read, an article by Moira O’Neil entitle

Pension planning: annuities back on the table

Annuities are on the table for the FT’s sophisticated readers and for good reason. The annuities purchasable in the barren years of QE were a dish served cold with the lifetime income available to investors being so low, that few readers would have had sufficient risk aversion to swap market risk for the certainty annuities give.

The chart below, taken from Moira’s article shows that the annuity rate you get is  aligned to the gilt rate. The “value” of the annuity is the difference between the darker blue line (the gilt yield) and the income you get- the peak of the light blue background.

Paradoxically, at time like now where rates are relatively high, the gap is narrower. Back at the start of this decade, annuities were delivering maximum compared to just purchasing 15 year gilts.

This has led to a rollercoaster of rates offered by insurers to the general public. The 30-year  from an age-60 annuity bought for £100,000 would have varied from £125,000 in July 2021, to £204,000 in October 2022. It then fell to £180,000 in April 2023 before reaching £199,000 in September 2023.

This is the risk that those who designed lifestyle back in the early years of the century were most worried about. It is ironically, almost entirely ignored by our generation of savers though I suspect that if you bought an annuity at anything other than at high guaranteed conversion rates five years ago, you will be looking at this chart with considerable regret that you couldn’t “hang on”.

Hanging on

Timing the purchase of an annuity is fraught by the volatility of rates (we know the past , we can only guess at the future). There is, as there is among pension trustees, a group of purchasers who are buying now – while rates last. They take the view that interest rates will fall and fall fast and drag annuities down with them. Others are more sanguine. Billy Burrows is quoted by the FT

“As inflation is tamed, I expect annuity rates to drift downwards but I don’t expect this will happen suddenly”

There is always the opportunity to hedge the chance of rates going up instead of down by purchasing a convertible annuity where the rate can be reset at a later date, typically 3 or 5 years after purchase, but the cost of this option is in the initial rate and the future rate depends on how competitive the future rate is. It’s a bit like betting on a horse in running. it’s speculative purchasing that demands deeper insight and stronger nerves than most of us profess.

Smoothing the volatility.

While most people wouldn’t consider an annuity in payment as anything but a “safe bet”, the timing of buying an annuity is anything but a risk-free business.

The following chart, produced by First Actuarial , shows how the valuation of pension scheme assets and liabilities (both now dominated by the gilt rate) have tracked each other over the past ten years

Eagle-eyed viewers will not that there are two lines that remain remarkably flat, they are both linked to the best estimate long-term returns of the pension scheme’s funding. It is this more certain approach to the past, present and future, that pension schemes used to adopt before the market values of assets and liabilities were used to determine the health of the pension.

Decupling the rate at which annuities were priced from the market rate of gilts could lead to a much smoother pricing approach where people would not be afraid to take decisions. Even better, were annuities to diversify assets so as not to be subject to the “tyranny of the gilt rate” , we might seethe pricing of annuities as smooth as that light blue line in the chart above.

The pricing of a CDC pension could well be set on the basis of the light blue line, as could a scheme pension offered by a DB scheme offering conversion factors for transfers in of DC pots.

Is now the right time to buy an annuity?

So long as the price of an annuity is yoked to the price of gilts, the timing of purchase is going to present savers with huge trauma. Put simply, pressing the Submit button to transfer a pot to a wage for life is something that takes a lot of guts.

The best thing we can do to help those who want an income not a pot, is to take the purchasing trauma out of the decision. I believe that occupational schemes should be looking to provide scheme pensions with stable conversion rates and CDC could do the same. But for this to happen, we need to get away from seeing “gold plated”  as being “gilts-priced”.  Fixed interest does not equal fixed price and the marked to market approach to annuity pricing is at the heart of the uncertainty people have with the “nastiest, hardest problem in finance”.