A silver lining for pension annuities

Some good news for those people buying annuities, even though the world economy is going through significant changes which we are all suffering from. There is an adverse impact on house, food and utility prices. However, with this particular cloud, there is a silver lining. Annuities are cheaper than for some time, which means anyone retiring can enjoy a boost to their pension.

The gilt and bond market has been through a relatively challenging period recently, linked to the credit crunch, the expected rise in UK inflation and uncertainty about interest rates. This has had a knock-on effect on annuities. Annuity rates are now at their highest for five years and developments in the bond markets recently suggest that attractive rates will remain in the short term at least. It could be a good time to buy that annuity.

Statements from Jean-Claude Trichet, President of the European Central Bank, have been interpreted as signalling an upward move in interest rates despite economic conditions. Gilt yields have jumped in response.

So what has happened in the market in recent months to cause such a rise? Gilts are issued by the Government to raise money, and pay a fixed interest in return for the loan, their main attraction to investors being security.

Corporate bonds are issued by companies and work in a similar way, but compared with Government bonds are less secure as they have a higher risk of default.

Towards the end of last year, following the Northern Rock crisis, we saw a degree of panic among investors who, in a flight to quality, sought greater security of investment return.

This meant demand for Government gilts rose significantly. In tandem there was a reassessment of risk on corporate bonds, which were perceived to be more risky than their price implied. Investors therefore pulled out of bonds, causing prices to fall.

Previously, ’spreads’ (the difference in yield between bonds and gilts) were around 1%, implying that 1% was a reasonable reward for taking the risks that companies might not make payments. Investors, however, concluded this was not an appropriate differential, and demand for, and the price of, corporate bonds fell.

The combined effect of high demand for gilts and low demand for corporate bonds pushed the difference in yields between the two types of investment to historically wide levels in the last quarter of 2007, with investors demanding an extra 2.5% per annum return for investing in corporate bonds rated ‘A’ by Standard & Poor’s.

However, in recent months we’ve seen spreads narrow again as gilt valuations have started to fall back and bond valuations have started to rise, which suggests that the market had overreacted.

One aspect of the market at present is uncertainty, and this is affecting all asset classes. Some experts believe that investors are seeking out returns wherever they can be found and to a large degree the fundamentals, that is the core statistics normally used to assess the value of the bond such as the likelihood of companies being able to make interest or principal payments, are largely being ignored. Consequently there is still significant volatility in the market.

This market activity has impacted on annuities, which are priced on the expected returns on the investments that back them, mainly corporate bonds. When product providers set annuity rates they look at the rate they expect to earn on assets that they invest in, such as long-dated corporate bonds. Over the past year the rate on corporate bonds has increased, and so too have the annuity rates on offer. The amount of income you can buy with a £100,000 fund has increased by more than 6% since the start of the year.

Whether these high rates continue depends on whether insurers can continue to invest to get these high returns. This in turn depends on how the market continues to view the risk of investing in corporate bonds, and how it views long-term interest rates, which will affect gilt rates.

We are starting to see some reduction in spreads as some confidence returns to the corporate bond market. However, spreads are still well above long-term levels and it will take some time to get back to levels based on fundamentals.

The good news for those about to cash in their pension pots and buy an annuity is that it looks like rates will continue at these relatively high levels for some time.