How stubbornly low gilt yields are impacting the bulk annuity market

One is forced to ask why this might be. I would like to suggest that there are a number of reasons.

First, and most importantly, is that the cost of bulk annuities is not something that can be looked at in isolation. It is the cost when compared with the value of the assets being given up that is critical.

Even before the events of 2008 many schemes were adopting some form of liability-driven investment strategy that has led them to hold significant quantities of gilts and corporate bonds.

The same economic factors that have led to the high absolute price of bulk annuities have also led to the value of the matching assets being held by trustees also being high. Thus, they have to sell the same number of the bonds to buy the annuity as previously. In these terms low gilt yields have not led to annuities being more expensive.

Second, and associated with the increased holding of bonds, is the type of bonds held. Given that trustees have to consider the liabilities in respect of deferred members and pensioners, many trustees have held bonds of a longer duration to those needed to match pensioner liabilities being secured by the bulk annuity policy.

So as yields fell and the yield curve changed shape, many trustees found the value of their specific portfolio of bonds increased more quickly than the cost of the matching annuity. Therefore, for some, annuities have effectively become better value.

Finally, the price of inflation has been changing over the past 18 months. Most pensions now have a degree of inflation protection and so the costs of securing inflationary increase affect the cost of a bulk annuity policy. Once again the shape of the inflation-adjusted yield curve has frequently changed to offer opportunities to secure benefits on beneficial terms when compared with the assets held.

So on the basis that low gilt yields are not necessarily bad for the bulk annuity market, why have we seen such a surge in interest in bulk annuities? 

Irrespective of the items listed above, bulk annuity providers have been refining and improving their business models. An increase in the number of medically underwritten annuities has helped, especially at the small end of the market.

In addition, providers have begun to examine assets other than gilts to support their pricing. As they have looked further to corporate bonds and other investments, prices have improved – albeit at the whim of closing yield spreads.

The main reason for the high level of deals in 2014 is a continuing trend within UK companies to reduce the level of risk taken within their pension arrangements. A bulk annuity purchase is a natural next step along the path that started with the purchase of bonds in the first place. 

In many cases the company and trustees can secure an annuity for a price similar or lower than the cost of covering those benefits in the scheme. By converting their low-yielding bond holding into a bulk annuity, they cover the same benefits – but with the added advantage of longevity insurance. Indeed, for many such an approach is also a better way of providing inflation protection than a traditional derivative solution.

A bulk annuity is a natural step on the journey to the ultimate aim of a full buyout; a derivative could be a diversion from that path, since it is likely that it would need to be unwound before a buyout could be completed.

John Reeve is a senior consultant at Premier