The UK government's gilt issuing policy may not only be affecting annuity values but also the prospects of deferred members of pension schemes which are winding up.
Gilts, the common name for public debt or bonds issued by the UK government, are the basis for annuities as they offer a guaranteed rate of return over a certain period of time.
However, as more pension schemes have moved into gilts over recent years as part of scheme funding plans - to reduce deficits and match liabilities - the price of gilts has gone up.
In May 2005, the Debt Management Office (DMO) - an executive agency of HM Treasury - started issuing 50-year gilts but a report for the Department for Work on Pensions (DWP) on annuity pricing, published this March, says while this move has “addressed the problem to some extent” there is still an “insufficient supply” of gilts to “satisfy the potential demand by insurance companies and occupational pension schemes”.
This is causing a problem not only in annuities, where the scarcity of gilts has pushed up the prices and reduced the returns, but also for deferred members of pension schemes which are winding up, as the regulations specify they must buy annuities to cover their liabilities to existing pensioners.
Combined with the demand of ongoing pension schemes trying to match their long-term liabilities with long-term bonds, the increasing price of gilts means the compulsory purchase of annuities is leaving significantly less money in the funds to meet the liabilities of deferred pensioners.
Peter Lapinkas, a member of a pension scheme which wound up, and part of the Pensions Action Group (PAG) campaigning for compensation, says he asked James Purnell, minister for pensions reform, why the Treasury could not increase the supply of gilts to bring the market back into balance.
In his reply, Purnell said the number of gilts issued by the DMO is limited by the amount the government needs to borrow in the year ahead, and although this mainly takes the form of gilts it also includes short-term debt and National Savings & Investment (NS&I) vehicles.
As the DMO’s primary objective is to “minimise, over the long-term, the costs of meeting the government’s financing needs”, Purnell stated in his letter if the level of yields was raised to a “market determined level” this would raise the cost to the government which would “conflict with the current policy objective of long-term cost minimisation”.
However, he adds the DMO’s remit for 2006-07 will see a financing initiative of £63bn, with the government having decided the DMO should “skew” the issuance “further towards long-dated conventional and index-linked gilts, partly in response to demand from market participants, including major pension funds, for long-dated assets to match their liabilities”.
Lapinkas says although the DMO currently plans to “issue a record absolute amount” of both long-dated and index-linked gilts, he argues it will not be sufficient to bring the market back into balance.
“The Treasury seems to be benefiting directly from the enforced increase in the price of gilts, but the irony is the initial justification for this, protecting pensioners through guaranteed returns, has a gaping hole in it,” says Lapinkas.
He says while annuity returns look reasonable at the moment, it should be remembered they will not be payable for another 20-30 years and if inflation over that period becomes less beneficial than at present, he warns the value of annuities would be destroyed within a few short years and the ‘guarantee’ could prove to be an illusion.
And while there are alternative investments to government bonds such as corporate bonds, overseas bonds and mortgage-backed securities, the DWP report shows these are not very popular as there is no desire by company treasurers to issue long-term index-linked bonds, while overseas bonds carry currency risk. One of the largest potential issuers, the US Treasury, stopped issuing bonds dated for more than ten years in 2001, although 30-year T-Bonds were reintroduced in February this year in response to institutional investor demand.
Rachel Vahey, head of pensions development at Aegon Scottish Equitable, says it is true it is still very expensive for people to buy annuities at the moment as the lack of raw materials - ie gilts - is pushing up prices.
On the other hand, she points out annuities are the only decumulation solution which assumes no risk whatsoever for the individual from longevity, and the higher price can be seen as a trade-off for this peace of mind.
But she adds: “The Treasury is under immense pressure to look at the gilts situation. It is currently looking at decumulation as a whole at the moment, but it certainly needs to consider this in line with gilts and longevity risk.”
Tom McPhail, head of pensions research at Hargreaves Lansdown, meanwhile says the lack of gilts and the rising cost of annuities will only be made worse by the introduction of personal accounts.
He suggests the majority of people entering the new scheme will want to annuitise and as there won’t be enough gilts to meet the demand the yield will go down, meaning these savers will have a lower income from their savings.
However, as he points out, annuities are the only product available at the moment which offers this guarantee against longevity risk, and with the future of drawdown past the age of 75, otherwise known as alternatively secured pension still uncertain, it seems pension schemes and their members will have to continue to rely on the gilt issuing policy of the UK government to make sure their retirement income does not fall too low.
If you have any comments you would like to add to this story or would like to speak to its author about a similar subject, telephone Nyree Stewart on 020 7968 4558 or email [email protected]IFAonline
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