Some thoughts for private investors particularly for those with pensions and annuities

Yesterday was an extraordinary day for world stock markets. There were falls overnight in Asia followed by heavy falls in Europe and then the United States joined in at her opening. However in the later part of her trading session the American Dow Jones Industrials index rallied to close only 22 points down. This compares with her being nearly 300 points down at the peak of the fall. As ever there were various rumours as to why we had dropped with the Korean crisis being a rather weak one (as it had been escalating for some time and the market had previously ignored it) and Spain’s banking problems being another. Of course in the background we have the slow drip drip rise of interbank lending rates also. One might wryly observe that as these were all true in the rally which took place were they responsible for that too?! Anyway European markets have recovered around half their losses this morning.

Treatment of Investors in these markets

When we see such days of instability and wild swings I often wonder how the private investor is treated. To explain my point consider two people one who was investing in an equity fund and for simplicity let us say there were buying American equities and another who was vesting a  pension and taking an annuity.

The person buying American equities would hope to get in as  near as possible to the 300 point drop as plainly they would like to buy as cheaply as they can. But they would be given say the midday price. On the day they might be reasonably happy with that as falls had taken place. But what if they got the closing price? then they would be much worse off. You see volatility like yesterday makes life very difficult for private investors in say a fund who wish to make changes. Often you may have to wait a day or two for the change to be made and at these times the change you are aiming for may already have happened. Not easy is it? The world has got more dangerous in my view for the private investor.

Now consider someone vesting their pension plan for an annuity on retirement. Let us assume they are invested in equities for a reasonable part of their fund. For those unaware of an annuity it is a product which guarantees an income for the rest of your life and possibly for the rest of your spouse’s life too. Here there is an enormous risk for not only do we have the investment risk as in what price our retiree will get for his shares and investments which is the mirror image of what I have described above but we also have the risk of choosing an annuity and what price he or she gets for that. In some ways this is one of the biggest investment decisions of anyone’s life as you are committing yourself for the rest of your life and whilst there are some alternatives to it most people take this route. You are now taking on an interest rate risk where you are locking yourself in effectively until death.

Now interest rates and for this I will use government bond yields are moving quite substantially at the moment. Imagine you had been in Greece and thought that say 6% government bond yields had been  a chance to lock in to an annuity for the rest of your life at a good rate and then they went to double figures and are now at the ten-year level  yield 8%. Even worse what if you had committed a year ago when annuity rates would have been based on government bond yields of 5.26%. So you do not get the day-to-day, hour to hour or even minute to minute moves with annuity rates that you do with equities and other investments but they do move. These days  they are usually also partly based on corporate bond prices but the principle remains that long-term interest rates are swinging quite wildly (for them) and some individuals at quite an important period in their life are having to make investment decisions based on them. Three months ago today UK ten-year government bond yields were 4.04% and last night they closed at 3.47%.Now annuities will usually be hedged against slightly longer dated gilts but I hope that you get my point. To add to it I can quote from a reply I gave recently to a comment here on inflation and index linked bonds. I have been following these and the longest dated UK index linked bond stretches to 2055 and as there are index-linked annuities this would be an ideal instrument for insurance companies to use as a base for the annuity. However on a price which has currently around 125 I have seen it move 5 points in a day. This is extraordinary instability for an instrument that if you think about it offers a real return and hence should actually be one of the most stable investments.

So I hope that you can see that the world with its current instability has got a lot more dangerous for the private investor as we are seeing quite wild swings in prices and investors sometimes have to make quite long-term decisions based on them. Annuity prices do not move on a day-to-day basis as they tend to move more slowly responding to changes on long-term interest rates.

Opinion and Comment

Firstly if you have a pension plan please go and get the details out and think about where it is invested and if you are happy with that. This is always important but is more important the nearer you get to retirement as hopefully your fund is at its largest and so you are taking the highest investment risk. It is also true at that time that you have the least ability to refresh the funds.

Secondly and I wish to be clear that this is not repeat not investment advice but merely opinion I do have some thoughts on long-term interest rates and hence annuity rates. If you are today taking out an annuity ( and by this I mean a fixed rate one) you are in effect locking yourself into rates which on a historical basis are very low. If you look at the UK’s record we have had over the period of my time studying and following them many periods of much higher rates. As you are committing yourself for life then if say today was my day for vesting a pension I would wait for a better day and (hopefully) higher rates. I would also refer you to my articles on UK inflation rates and the way that inflation has persisted in the UK and hope that  you would see that if anything like the current rates on inflation persist going forward then annuities at current rates are going to have the real value eaten away over time and possibly quite quickly. Remember that Consumer Price Inflation is at 3.7% and Retail Price Inflation is at 5.3%.

Whilst I referred to UK interest and inflation rates much of what I have written today applies abroad too I think. Look at Germany where her ten-year government bond yields touched 2.56% or the United States where her 30 year government bond yields dipped below 4% yesterday.

Where could I be wrong?

I think there is one main scenario and that is where the world plunges into a severe recession that is sustained and becomes something like the depression that was seen in the 1930s. This is not impossible and in my view many governments have made it more likely by instituting the policy errors I have discussed in this blog. However long-term interest rates are pricing quite a lot of this in now in my view. I also feel that some momentum has begun and over the next few months long-term interest rates could fall further but I today am trying to look beyond that. After all if you are retiring today with current levels of life expectancy you could live for 20/30 or even 40 years.

I guess the real example of where I would be wrong would be if we got ourselves in such a mess we became more like Japan and her “lost decade”. I was reading the thoughts of Adam Posen who is on the Monetary Policy Committee yesterday on this subject and will discuss this further in future articles but Japan I guess with her sustained disinflation and ten-year bond yields of 1.3% is an example of a scenario where if we became it, my opinion would be incorrect.

I would just like to end by repeating that this is not investment advice as the FSA is strict on this sort of thing but purely my personal opinion and views. I rarely see this sort of matter discussed and hope that people find it helpful. The issue of this being a very difficult time for private investors is also I serious issue I think as we are in danger of finacial markets dislocating from the ordinary individual or perhap I should say even more so than they do already.

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7 thoughts on “Some thoughts for private investors particularly for those with pensions and annuities

  1. Quite why the annuity model has survived as a sensible way of planning for retirement escapes me.As you rightly point out retirees welfare is predicated on prevailing asset values and discount rates on one day out of the probably 15,000 of the pensions existence.

    Surely it’s time to have something more like a 401k where a wide range of asset classes can be collected them gradually drawn down beyond a certain age.

    This would enable the individual or plan manager to gradually adjust the weighting from risk assets (eg equity) to protection assets (eg bonds). That said at this time I doubt that bonds offer little protection.

  2. Shaun, I enjoy your blog, finding it only about 1 month ago. As an IFA I can comment.
    Andy of yarm.
    There are already alternatives to an annuity, but these are more risky. Drawdown is OK if the client is happy with the risks and understands it. Imagine taking income out and then the fund falls by another 10%20% or even 30%. How many clients are happy with that in retirement. Most clients do not have a large fund nor do they want risk. There are also investment linked annuity’s to help.
    An annuity is in effect insurance for living to long. The annuity is guaranteed for the rest of the persons life (and maybe a spouse). Most clients do not want risk when they are retired and think only short time. Most decline the annuity that increases at 3% or RPI, due the lower starting income and the time needed to catch up the level annuity, about 13 years. A actual profit takes nearer 20 years.

    Buying an annuity now will lock you into a low interest rate now, but this has to be weighed up against he loss of income by waiting for 1 or 2 years and for interest rates to improve. Annuity Rates may become worse due to longer living, and EU changes about to hit the Ins. Company.

    • Hi Colin and welcome

      I understand that there are other issues in the annuity market but have felt for a while that because for a while now long term interest rates have fallen everybody has got into a mindset that they can only fall. We have had a 20 year bull market in long term interest rates and for various reasons I feel that this is ending. I do not know that it will end today or even tomorrow but I think that we are heading to that point. I know that there are other issues which influence annuity rates but I feel that the move in interest rates if it comes is likely to be quite large.. Not necessarily anything like Greece but long term rates of over 5% are quite conceivable. But for the “flight to quality” that has taken place recently we may have been well on our way there already.

  3. Colin – the outcome of your explanation points to a dilemma for the majority of retirees. None of the options are very satisfactory against the current economic backdrop for the averaged sized UK pension fund.

    My preferred strategy is for a combination of index linked annuity, fixed annuity and a portion of pension fund left unvested. This provides ultimate flexibility for those that can afford it. But, herein lies the problem, as for those with smaller pension funds, this is probably impractical and not very cost effective, so they end up buying a level annuity by default and will get savaged if inflation continues to gather steam. This is why the pension retirement options, as they stand now, stink.

  4. Colin you are quite right the annuity is priced for mortality assumptions,which are going north. Survival longevity is a big problem in pension provision ,in fact I’d argue it is the biggest reason that non state provision is failing to deliver the goods. Except for Local government Pensions where asset management is carried out in house,those guys are stars.

    My pet solution is the have generous state pension provision for over 80 year olds. Up to age 80 you have to make your provision (although there would be an optional state administered scheme for the). It then basically up to you when to retire based on the amount saved at any particular age. Certainly a far more efficient market in annuity type products would emerge where you could say “My pot is £235k,I am 66 today.How much would you pay annually between now and when I reach 80 or die (whichever the sooner)”?

  5. Your point about Private Investor getting a raw deal because of intra-day volatility is well taken. Here is the worst that could have happened in one-day. Have a look at the valuation of the New Star (now Henderson) Indian Equity GBP income fund and the valuation around 15th and 18th May 2009. In one day, the valuation changed from 500 to 600, by a whopping 20%. I have never understood how valuation could change by 20% in a day. The Indian market has a circuit breaker at 10% rise or fall, so there is very small chance that the value of a fund could change by 20% in a day. I wonder if anyone got caught on that day.

    Even otherwise, I have tried to find out the logic of valuation points and tried to time things, but have always failed to get anything but the raw end of the stick for a fund buy/sell deal. Thanks for mentioning the problem in your post. I hope FSA looks at this issue a little more carefully.

  6. From 2012 life companies will be obliged to value their annuity liabilities using government gilt rates, rather than the current preferred option of corporate bonds, which give a higher yield.

    Annuity purchase will remain an important means of generating retirement income, most especially for small pension funds. For many retirees staying invested is fraught with risk, large investment losses in the early years can rarely be clawed back, and who can predict when these losses will occur, or their magnitude?

    There are alternatives, where either capital value or future income flows are guaranteed by the pension provider, but then there is a new risk to weigh-up: counter-party risk. What is the provider of the guarantee doing across the range of its activities which may ameliorate the reliability of that guarantee.

    Not that there isn’t counter-party risk in the annuity market: which has seen new types of entrants – private equity and the like – looking to grow their share of the UK annuity market.

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