Locking In Annuity Rates?

Triumph13

I have a friend who would be a perfect candidate for an annuity.  No dependents, very risk averse, no existing DB pensions apart from the state pension.  He’s reached the point where he almost certainly has enough in his pension to fund his retirement, and now he’s looking to downshift and just tick over until pension access age.

He’s the kind of person who worries if 2.5% is too aggressive a withdrawal rate, so, if he could get an annuity at current rates, he’d probably bite their hands off, at least for enough to establish a decent floor to his income.  The problem is that he’s only 48 and so has nine or ten years until he can access his pension and actually buy said annuity.  He worries that, by the time he gets there, annuity rates will have crashed again and, as you don’t seem to be able to buy deferred annuities in the UK, I was wondering if it was a workable strategy to try and largely lock in the current rates (and take advantage of the current high values of his equity investments) by investing in an index linked gilt fund such as Vanguard’s UK Inflation-Linked Bond fund.  The theory being that the value of the fund should largely move in the opposite direction to annuity rates, so, if rates go down, the investment value goes up and you still get much the same income.  RPI linked single life annuities currently pay around 4.5% at 58.  If he could be pretty certain of getting say 4% by going this route, then I think he’d be pretty keen on it.

Does the forum brains trust think this is a workable approach, or can you suggest a better one?  I know ten years is a long time to be out of the equity market, but if you’ve already won why keep playing?

Marcon

Triumph13 said:

I have a friend who would be a perfect candidate for an annuity.  No dependents, very risk averse, no existing DB pensions apart from the state pension.  He’s reached the point where he almost certainly has enough in his pension to fund his retirement, and now he’s looking to downshift and just tick over until pension access age.

He’s the kind of person who worries if 2.5% is too aggressive a withdrawal rate, so, if he could get an annuity at current rates, he’d probably bite their hands off, at least for enough to establish a decent floor to his income.  The problem is that he’s only 48 and so has nine or ten years until he can access his pension and actually buy said annuity.  He worries that, by the time he gets there, annuity rates will have crashed again and, as you don’t seem to be able to buy deferred annuities in the UK, I was wondering if it was a workable strategy to try and largely lock in the current rates (and take advantage of the current high values of his equity investments) by investing in an index linked gilt fund such as Vanguard’s UK Inflation-Linked Bond fund.  The theory being that the value of the fund should largely move in the opposite direction to annuity rates, so, if rates go down, the investment value goes up and you still get much the same income.  RPI linked single life annuities currently pay around 4.5% at 58.  If he could be pretty certain of getting say 4% by going this route, then I think he’d be pretty keen on it.

Does the forum brains trust think this is a workable approach, or can you suggest a better one?  I know ten years is a long time to be out of the equity market, but if you’ve already won why keep playing?

Maybe a better approach would be to encourage him to get some proper (paid for) financial advice, based on a full understanding of all relevant factors? A few lines of background isn't the best starting point for someone to take decisions which could impact on their future financial security - and would you really want to be responsible for passing on the 'wisdom' of random strangers on the internet who have no information other than that contained in your post? Well meaning is never the same as well informed.

QrizB

I think someone cleverer than me - I think it was @OldScientist - has suggested you can achieve this end by buying an IL gilt where the duration matches "half the unisex life expectancy".

For someone who is 48, expecting to live to 88, that would be a 20-year ILG.

I think it was this post:

https://forums.moneysavingexpert.com/discussion/comment/81639889/#Comment_81639889

(Do check the whole thread, there might be complications that I've overlooked!)

Triumph13

ThanksQuizB, that's exactly what I was looking for. And silly me for not searching first to see if it had come up recently.

OldScientist

Just to add: Bear in mind that effectively matching to a deferred annuity is an approximate process. I've done some preliminary (i.e,., unfinished) historical modelling of the outcomes for nominal annuities (there's more data than for ILG) which suggests that while the expected income can be locked in to within about 5% most of the time (i.e., if you were expecting an income of £1000 you'd end up with somewhere between £950 and £1050), the worst cases had a tracking error of upwards of 15% (i.e., between £850 and £1150). I've not yet finished the analysis (I've got distracted by other things!), but my initial thoughts are that the worst cases occurred when there were very large changes in yields over the course of delay between gilt purchase and annuity purchase.

Two funds (e.g., the under 10 year ILG fund by ishares and 'all stocks' ILG funds offered by various fund houses) could be combined to provide an average duration around the right value (roughly half the unisex life expectancy at annuity purchase plus the delay) - this would be an ongoing process since the weighting towards the shorter fund would gradually increase with time. I've yet to model this, but would expect similar outcomes.

In reality this is a variation on the generalised 'lifestrategy for annuity purchase' offered by many pension platforms.

Thinking about the required income floor in retirement might help decide on precisely how much to commit to this strategy - the rest can be left invested normally.

Bostonerimus1

QrizB said:

I think someone cleverer than me - I think it was @OldScientist - has suggested you can achieve this end by buying an IL gilt where the duration matches "half the unisex life expectancy".

For someone who is 48, expecting to live to 88, that would be a 20-year ILG.

I think it was this post:

https://forums.moneysavingexpert.com/discussion/comment/81639889/#Comment_81639889

(Do check the whole thread, there might be complications that I've overlooked!)

Triumph13 you are right.

Annuity rates basically track gilt rates and so as someone approaches retirement the "lifestyling" type funds will move to a more gilt and bond oriented portfolio to lock in your buying power for a lifetime annuity. The problem with this approach comes if a drawdown strategy is followed when an increase in interest rates and a corresponding fall in bond values invites sequence of returns problems. This can be mitigated by using an individual bond ladder held to maturity or, as you originally said, by using a gilt/bond fund allocation to buy an annuity.

SVaz

Is it Always the case that when bond prices fall, yields rise and Annuity rates are higher?

So if you had £100k in a 100% bonds fund that dropped to £75k,  it doesn’t matter because the annuity income is the same / similar either way? 

Are there any circumstances where that wouldn’t happen?  

I’m sorted for income until I’m 74, in 14 years time,  after that then using half my pot for a joint life annuity might be a good idea.
I remember Dunstonh saying that you can have it paid into a Sipp,  which would be handy if you don’t need the income - if, however one of us died then it would be needed.  

snowlaser

Most schemes will offer funds which broadly correlate with annuity prices - in my scheme it's called "Index-Linked Annuity Matching" but will no doubt differ.  You friend could invest some of his fund in that to hedge against changes in annuity prices.

Alexland

SVaz said:

Is it Always the case that when bond prices fall, yields rise and Annuity rates are higher?

Changes in general life expectancy, annuity industry profit margins or the medical diagnostics they might be able to run in the future to determine your personal life expectancy could also affect the annuity rates you have access to but for now they generally seem to follow gilt yields as the biggest factor.

itwasntme001

Annuity rates are a commercial decision by the providers, but the assets they need to buy to fund their liabilities will be a big component of the annuity rate pricing.  Competition is another factor.

I think we saw annuity rates not come down in commensurate to bond yields (real and nominal) falling in the years leading up till 2020/21?  Perhaps because annuity demand was low and providers had to sacrifice their margins to get business?

So I think there is no perfect hedge, and things get more uncertain with this matching under extreme conditions.

OldScientist

SVaz said:

Is it Always the case that when bond prices fall, yields rise and Annuity rates are higher?

So if you had £100k in a 100% bonds fund that dropped to £75k,  it doesn’t matter because the annuity income is the same / similar either way? 

Are there any circumstances where that wouldn’t happen?  

I’m sorted for income until I’m 74, in 14 years time,  after that then using half my pot for a joint life annuity might be a good idea.
I remember Dunstonh saying that you can have it paid into a Sipp,  which would be handy if you don’t need the income - if, however one of us died then it would be needed.  

Sorry for the rather extensive answer...

 The pricing of annuities depends on projected life expectancy, expected asset returns, and fees (e.g., see https://retirementresearcher.com/income-annuity-101/ for the basic method). Values for each of these may very well vary between insurance companies which leads to the difference in available payout rates (e.g., on 1/10/2025 a single life RPI annuity at 65yo had payout rates between 4.91% and 5.28%). For example,
1) Life expectancies are provided by the Institute and Faculty of Actuaries (see https://www.actuaries.org.uk/learn-and-develop/continuous-mortality-investigation/other-cmi-outputs/unisex-rates-0), although health and other factors (e.g., postcode) are considered.
2) Expected asset returns will depend on what the insurance company is invested in (gilts, corporate bonds, infrastructure, etc.). An approximation is to use gilt yields (e.g., see the calculator at https://lategenxer.streamlit.app/Annuity_Valuator ).
3) Fees will also vary between insurance companies.

Assuming 1) and 3) are constant, then the annuity payout rate will depend on yields - so as yields go up, the payout rate will increase and vice versa. The magnitude of change in payout rate will depend on the duration of underlying assets of the annuity - this can be approximated by assuming gilts are held - increasing yields will decrease the duration of the annuity while increasing life expectancy will increase the duration (this means that the duration gets shorter at later ages). I've mentioned on these boards before that the duration is approximately equal to half the life expectancy but the duration also depends on yield (and given that we don't actually know the underlying investments or fees, this is a very rough approximation).

Interestingly, research (US based, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2021579 ) indicated that "Annuity prices react more rapidly and with greater sensitivity to an increase in the relevant interest rate compared to a decrease" (in other words in favour to customers!).

Finally, the change in NAV of a bond fund is dependent on the weighted modified duration which will in turn depend on the bonds held and their yields.

To take an example, assume the bond fund and the annuity both have a duration of 10 and yields increase by 1 percentage point. The payout rate of the annuity will increase by roughly 10% while the NAV of the bond fund will decrease by 10%, so the overall income from an annuity purchase will stay the same as before the change in yields. Note that the duration of both annuity and fund would change after the change in yields, but not necessarily by the same amount.

However, if the duration of the bond fund was 15, then a 1pp increase in yields would mean that the NAV would fall by 15% and the amount of income after annuity purchase would be reduced (roughly to 1.10/1.15=0.96).

A step change in life expectancies (e.g., a cheap cure for cancer) would temporarily disrupt the link between payout rates and yields (and would have the opposite effect on life insurance premiums).