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
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.
Let us imagine, for the sake of argument, one insurer assumed a rate of return of 4 per cent above gilts to reflect its investment in corporate bonds and a diversified portfolio of higher risk assets. This would be its discount rate put into a formula to discount back to the sum initially invested. That calculation would be adjusted to allow a profit margin for the provider in order to generate an annual pension the insurer was prepared to guarantee for life.
While the process is largely the same for all insurers, their assumptions change subtly all the time, partly to reflect the ebb and flow of business volumes, which is why prices move all the time and why one insurer may offer your client the best deal on one day and a completely different price the next. Some insurers may assess longevity in a way that will benefit or be detrimental to your client compared with another insurer. What they all have in common is a direct link back to gilt yields – the risk-free rate that lies at the heart of the pricing system, and which tends to be the biggest single factor for conventional annuities.
There are many other factors that affect pricing as well, so it should not be a surprise to see the gap between gilt yields and annuity prices fluctuate over time. In fact, it is notable from Chart 2 that insurers tried to shield prices from the very low levels of gilt yields in 2011 and 2012, not fully passing on the drop in yields in an effort to make annuities more attractive. During this period, annuities were being priced at more than 3 per cent above gilts – the highest margin in a decade.
Annuities v drawdown
But as gilt yields have risen since January 2013 the margin has fallen, no doubt as insurers have attempted to balance out their profit margins. Retaining the attraction of annuities has been a constant pressure for annuity providers during the quantitative easing (QE) period.
For those with small pots or much older pensioners, annuities present the most sensible option almost irrespective of current pricing levels.
But for most others, drawdown is a real alternative. With Gad limits relaxed to allow income at 120 per cent once more in this period of low yields, drawdown has become a more attractive option for those who want to retain control over their pensions – particularly where there are children who stand to inherit anything left over. Insurers have been mindful that not only is there pricing competition among themselves but from drawdown pensions often preferred by IFAs.
The truth is that to really understand how annuities are priced, you have to be an actuary and there are few qualifications more arduous than professional actuarial examinations. Insurers could, nevertheless, help dispel the myths around their mystical practices by making the process more transparent and easier to grasp. The annuity market is heavily price-competitive and that in itself keeps insurers on their toes.
As Chart 1 demonstrates, the margin annuities are priced at above gilt yields has remained within the band of 2 to 3 per cent for the past decade, only going above that level in the recent past. The days of annuities being priced at more than 4 per cent above gilts is ancient history (as far back now as the 1990s).
The real problem for pensioners is persistent low gilt yields, but that has little to do with insurers and everything to do with the Bank of England. Although yields have improved slightly this year, annuity prices have been more stubborn because they had been more generous than usual during the preceding year.
Before we see sustained improvements in annuity rates, gilt yields will need much sharper upwards movements which the rhetoric of the ‘tapering’ of QE is designed to prevent. Yields are likely to be unpredictable in the short term as the market tries to find the right balance and adjust to life without QE injections, but more stable improvements in annuity rates could be some years away and there is little insurers can do about that.
