Pensions  

Annuity pricing and gilt yields

The mysteries of annuity pricing are revealed to but a few chosen initiates – or so it would seem to IFAs and their clients, for whom the process of buying an income for life seems as obscure as the dark arts.

The Financial Conduct Authority (FCA) shares its concerns, it would seem, after confirming it would push ahead with its probe into the annuity market despite attempts by the Association of British Insurers (ABI) to head off an investigation at the pass by introducing a new code of conduct earlier this year. The FCA is worried that profit margins of annuity providers are high, but is there really cause for concern or any reason for consumers to fear that self-regulation is not enough?

Disparity

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IFAs voiced concerns over annuity pricing at the end of last year when EU regulations forced insurers to equalise prices for men and women, despite the obvious disparity in the respective longevity of the sexes.

At the time many commentators feared that prices for women would decrease less than they would increase for men, and that the insurers may pocket the difference. In reality there was little evidence to support such fears, but concerns that annuities were becoming increasingly expensive have nevertheless amplified this year, a period in which long-dated gilt yields – which have always been highly correlated to annuity prices – have risen at a faster rate than annuity prices have improved.

Chart 1 demonstrates how the gap between annuity rates and gilt yields has narrowed in recent months. In July the difference fell to one of its lowest historical levels. The difference may not seem substantial, but even small fluctuations in rates can have a significant impact on retirement income and the recent downward movement has renewed suspicions that annuities are unnecessarily expensive.

Under threat

From the insurers’ point of view, while annuities remain a profitable business, they are under threat. As for all financial services and banking companies, the cost of doing business has steadily increased in recent years due to more onerous regulatory supervision and tighter risk management expected in the EU and globally. Life expectancy continues to rise, which means insurers have to pay out for longer and their costs rise. As with any other business, those costs are passed on.

But the sustained period of low interest rates and the relatively poor performance of stock markets has posed a different challenge. Annuities are priced at a margin above gilt yields because that is how insurance company actuaries evaluate the cost of paying a pension to an individual until they die. The process is largely formulaic, with the insurance company making assumptions about the longevity of the individual and other factors that are directly linked to the amount of pension paid; such as inflation for index-linked annuities. They will then make a standard assumption about the expected investment return to be gained from the lump sum committed at a rate above ‘risk free’ – for example gilt yields.