Index linked gilts and index linked annuities: are you moving money into them, yea or nay?

SnowMan

There has been a dramatic switch around in the real redemption yields on index-linked gilts recently (see my chart at end of post). 

The return above inflation available for an index-linked gilt bought today if held to maturity is for example around 1.5%pa for the 2048 maturity, compared with around minus 2.5%pa back in 2021. Note the change to linking to CPIH in 2030 had already been announced in November 2020. 

The cost of a single life pension annuity, increasing each year with inflation for a 60 year old is currently about £24 for each £1pa purchased. A few years ago you would have been looking at a cost of something nearer £35 for each £1pa purchased.

This creates a good potential opportunity for someone planning their retirement income to use index linked gilts, perhaps directly through the purchase of a ladder of gilts maturing at regular dates through their retirement and held to maturity, or indirectly through the purchase of an index linked annuity from a SIPP or other pension. This might add secure retirement income to your state pension or defined benefit pensions, meeting essential expenditure needs, with the rest of your retirement resources held in more volatile, hopefully higher returning investments.  
So my questions are
Have you started using, or are you considering the use of index-linked gilts? If so for what purposes? And if not why not, and what would real yields need to be to tempt you?
How are you going about this in practical terms?

This Schroders note from 2016 was a decent attempt at explaining why real yields on index linked gilts were negative then and were likely to remain negative. And of course government debt funding requirements coming out of the Truss budget and the current government have pushed yields up recently. But why do you think real yields are in positive territory now? And how have changes in the institutional (e.g. pension funds) demand for index linked gilts for liability matching affected real yields?  

   

najan49

Yes, I have started to diversify my portfolio from 100% equities a few years ago and am currently about 85/15 with the 15% in an index-linked annuity tracker fund.

I’m planning to retire in 3 or 4 years, depending on when my children’s university expenses finish.

Up until a couple of years ago I was 100% invested in global equities, but started to think about sequence risk and decided to start to implement a 5 year glide path.

My company pension has extremely low charges but also not very many fund choices. I ran some analysis to see which funds were least correlated to the global equity fund. The least correlated was the cash fund, which I discounted (for better or for worse). The second-least correlated fund was the index-linked annuity tracker fund. As I understand it, this fund invests in the same assets as an insurance company would buy to back index-linked annuities - primarily index linked bonds.

I began to diversify away from equities into this fund in April 2022 which, as it turns out, was about 6-12 months too early, but never mind.

By the time I get to 55 I’m aiming to have about 65% of my portfolio in equities and 35% in the index linked fund.

When the time comes I could either use the index-linked fund allocation to buy a linkers ladder or an index-linked annuity- or something else. I don’t need to decide that until nearer the time.

SnowMan

Seems like a sensible strategy najan49. I was 100% global equities for quite a long time, before moving down to 80% and now lower still.

If real yields go back down in the next 3 or 4 years, hopefully you should do well out of the index linked fund, as it will be continually rebalancing to maintain the term and you will benefit from lower yields meaning higher prices.

If real yields go up even further over the next 3 or 4 years you may have some losses on the index linked fund but will be able to buy that linkers ladder fixing in a greater real return. 

leosayer

My wife and I have enough inflation linked income via DB pensions and state pensions to not need to be concerned with IL gilts. My investments are in global equity index funds, short term (non-IL) gilt funds and cash funds.

To be frank, despite having worked in financial services my whole career, the pricing of IL gilts really confuses me. I understand the factors that drive bond prices but I really don't see what benefit IL gilts offer against inflation compared to a non-IL gilt.

Take Treasury 0.75% 22/03/2034 Index-Linked Gilt (TRTQ) linked below as an example. The price dropped over 30% since 3 years ago. What inflation protection does that offer? What benefit is there of holding IL gilts over non-IL if the you intend to buy an annuity with the funds?

https://www.hl.co.uk/shares/shares-search-results/t/treasury-0.75-22032034-index-linked-gilt/share-charts

Linton

I do not hold IL gilts and never have.  Inflation is a long term concern and for long term investing equities provide the best returns. The yields in £ terms are generally low so they are not worth holding for income. Fixed rate gilts ae currently providing a return higher than both current inflation and the market's exectations of long term inflation.

So why should small private investors hold IL gilts?  In my view they are more suited for holding by instituations to meet long term liabilities.

SnowMan

leosayer said:

My wife and I have enough inflation linked income via DB pensions and state pensions to not need to be concerned with IL gilts. My investments are in global equity index funds, short term (non-IL) gilt funds and cash funds.

To be frank, despite having worked in financial services my whole career, the pricing of IL gilts really confuses me. I understand the factors that drive bond prices but I really don't see what benefit IL gilts offer against inflation compared to a non-IL gilt.

Take Treasury 0.75% 22/03/2034 Index-Linked Gilt (TRTQ) linked below as an example. The price dropped over 30% since 3 years ago. What inflation protection does that offer? What benefit is there of holding IL gilts over non-IL if the you intend to buy an annuity with the funds?

https://www.hl.co.uk/shares/shares-search-results/t/treasury-0.75-22032034-index-linked-gilt/share-charts

The protection that index linked gilts provide is only if you hold until maturity and you choose the maturity date to coincide with when you need the money.

If you do that you essentially get a guaranteed real return as real yields are currently positive. And so broadly speaking can cover future expenditure requirements that are also going up in line with inflation, and you are protected from high/hyper inflation. Not required in your case but for others without that level of secure income they can be potentially useful.

In your example the index linked gilt isn't going to provide inflation protection over those 3 years. The reason the 2034 gilt has fallen in price is because the real return it was priced at 3 years ago was probably around minus 3%, and now it is priced at around 1% positive real return. So it's the  expectation of future real returns from 2024 to 2034 that has increased dramatically and caused the fall in price.

So if someone used that gilt to provide inflation protection over 3 years then they've made the mistake of mismatching the gilt in terms of term by buying a 13 year term rather than a 3 year term to maturity.

SnowMan

Linton said:

I do not hold IL gilts and never have.  Inflation is a long term concern and for long term investing equities provide the best returns. The yields in £ terms are generally low so they are not worth holding for income. Fixed rate gilts ae currently providing a return higher than both current inflation and the market's exectations of long term inflation.

So why should small private investors hold IL gilts?  In my view they are more suited for holding by instituations to meet long term liabilities.

When index linked gilts (ILGs) were first issued in 1981 their purchase was restricted to pension funds and similar institutions. And subsequently despite this changing the institutions have been the main holders of ILGs and still are. Going back a few years when real yields were negative (down to minus 3%) then the institutions still bought them because they had statutory requirements to match liabilities. At that time there was no obvious sense in private investors buying them because they were just buying themselves into something that would lose its real value over time.

Jump forward to now and ILG maturity real yields are in positive territory as much as 1.61%pa on the 2051 maturity. That potentially makes them suitable for individuals because the real return is positive.

When a retiree purchases an index linked annuity then there is an equivalence with buying an index-linked gilt ladder (as that's the main matching asset that the insurance company will buy to cover that liability and determines its pricing), with a bit of longevity insurance built in. 

I think most would understand why someone would buy an index linked annuity with some of their pension pot over a fixed increase annuity, because it protects them against high future inflation. 

So it follows that buying an ILG for example as part of a ladder to provide an inflation linked income to cover inflation linked needs would be better than buying conventional gilts to do the same thing in a scenario of future unpredicted high inflation after the purchase. That it's not commonly done isn't a suitability argument.

There are pros and cons to buying an index linked annuity vs setting up an ILG ladder, but they are essentially doing the same thing (leaving aside the longevity 'insurance').

It doesn't have to be a ladder, someone might just strategically buy some ILGs that mature around a future time in retirement when income is needed.

For someone in their 20s , 30s or 40s say who is not approaching retirement then I can't see the attraction of ILGs either because based on historical data we expect (or hope) that equities will outperform ILGs by some margin in the long term. But we are talking about people approaching retirement and planning their retirement income not people in their 20s

     

NedS

If my sole income in retirement was from a DC pot, then I would certainly consider an annuity or ILG ladder to help cover essential spending. But like many others, I have a mixture of DB, DC and SP income, and my essential spending needs are already well covered (with inflation protection) by DB and SP. 

Given a potential 40 year retirement window, 100% equity seems appropriate for the rest.

But I agree with your premise that ILGs are again investable for those requiring inflation protected fixed income. That said, I think it's hard to put a price on the longevity premium afforded by an annuity should you live into your 100s.

snowlaser

leosayer said:

Take Treasury 0.75% 22/03/2034 Index-Linked Gilt (TRTQ) linked below as an example. The price dropped over 30% since 3 years ago. What inflation protection does that offer? What benefit is there of holding IL gilts over non-IL if the you intend to buy an annuity with the funds?

The point is that whilst the gilt value has dropped 30% the cost of buying annuities has become cheaper too, so the actual amount of pension would get is similar.  The reverse would be true when yields fall.

The idea therefore is that it protects you against these yield/interest rate fluctuations - you neither gain nor lose when yields/rates change if you intend to buy an inflation-linked annuity at the end.

The correlation will not be perfect, but it will be a lot closer than with many other asset types.  For example, shares could collapse in price at the same time annuities are expensive, whereas IL gilts change in a roughly equal fashion to IL annuity costs.

zagfles

I'm now at the stage where DB plus state pension provides the core income we need, but I'm using IL gilts for 2 purposes, firstly to provide a gilts ladder to replicate the state pension for the years between retirement and state pension age, and secondly some very long dated IL gilts as a hedge against high inflation reducing the value of our DB pensions. 

I don't think people with DB pensions understand how much they can get decimated by inflation, unless they have uncapped inflation increases. The vast majority of private sector DB pensions cap inflation increases to 3% or 5%. A few years of high inflation could put a serious dent in the real value of the pension. Just one year of 10% inflation would chop 7% off a DB pension with a 3% cap, or 5% if the cap is 5%, and that's a permanent cut for the rest of your life. A decade like the 70's would over halve its value. 

FIREDreamer

zagfles said:

I'm now at the stage where DB plus state pension provides the core income we need, but I'm using IL gilts for 2 purposes, firstly to provide a gilts ladder to replicate the state pension for the years between retirement and state pension age, and secondly some very long dated IL gilts as a hedge against high inflation reducing the value of our DB pensions. 

I don't think people with DB pensions understand how much they can get decimated by inflation, unless they have uncapped inflation increases. The vast majority of private sector DB pensions cap inflation increases to 3% or 5%. A few years of high inflation could put a serious dent in the real value of the pension. Just one year of 10% inflation would chop 7% off a DB pension with a 3% cap, or 5% if the cap is 5%, and that's a permanent cut for the rest of your life. A decade like the 70's would over halve its value. 

An uncapped RPI annuity will do some of that, though won’t help with the real reduction in the DB pension of course (nor will the ILG really)