I was pulled up by Con Keating in a comment on a recent article on bulk annuities. Con reprimanded me after I’d said that annuities were priced against gilts (what I was told to say when I was selling “lifestyle” DC defaults (going into annuities)
I believe that BPA insurers actually price transactions against interest rate swaps rather than gilts – not that this technically makes much difference – 30 year swap this morning 5.03% versus gilt of 5.69%.
Bloomberg pointed out in a newsletter this morning that relative to governments, corporate borrowers are getting a pretty good deal.
The spread — the premium over government bond yields — that US high-grade issuers need to pay shrank last month to a 27-year low. While spreads have widened a bit they’re still far below their average over the past two decades.I had thought all this a little “technical” , meaning not important to the man (or woman) in the street, but I am wrong, The very good Andy Smith who works on the wrong side of the street (risk management) has his heart on the side of consumers and he can see where these mismatches between schemes in gilts and annuities that are priced against swaps – matter.
When considering a bulk annuity transaction, it’s not just the headline price that matters, it’s how that price moves. The insurer’s price-movement mechanism determines how the price changes between the initial quote and settlement. I’ve been looking at what impact a mismatch in underlying instrument (swaps versus gilts) could have, and thought the results were worth sharing.
The distribution of outcomes is shown on the charts. Taking a typical £50m scheme that’s invested in gilts, but the insurer’s price-movement mechanism is swap-based, then over the last 6.5 years:
➖ In around 8 out of 10 cases the scheme’s funding position would have changed by less than 1% either way – so not moving the dial significantly.
➖ On 22 occasions, the Scheme’s funding could have fallen by more than 3% – that type of swing could easily flip a transaction from affordable to unaffordable.
➖ In around 2 out of 10 cases, there would have been a funding loss of over 1%, which for a typical scheme would equate to a loss of £0.5m or more.
The opposite would be true if invested in swaps, but the price-movement mechanism were gilt-based. In that scenario, there would have been a gain of 1% or more in 2 out of 10 cases and a loss of more than 1% in less than 1 out of 10 cases.
So even small mismatches between the scheme assets and price-movement mechanism can carry real risks. When affordability is on a knife edge, those risks increase and could easily derail a transaction. The best way to mitigate this is close alignment between the assets and the price-movement mechanism, not only in terms of interest rates and inflation sensitivity, but also the underlying instrument.