Mark Joannes assesses the possible impact of forthcoming Solvency II rules on the annuities market.
Rarely a week goes by without some commentary on falling annuity rates. In a recent survey conducted with some of the country’s leading IFA annuity specialists, it revealed that 82% of them expect annuity rates to fall over the next five years. In fact, one in four expect them to decline by between 7.5% and 10% over this period, and nearly one in five expect a fall of over 10%.
It is well documented that the key reasons for the falls are increased longevity and economic conditions. Another reason for future predicted falls is Solvency II.
Solvency II rules are expected to be in force on 1 January 2013. The rules are believed to be close to final and are designed to ensure all providers can meet their financial obligations to their customers, avoiding future crises such as the Equitable Life scandal.
So how does annuity pricing work, and why is it that commentators predict that Solvency II will have a negative impact on annuity rates? Is it something we should all be concerned about now?
How annuity pricing works
To ensure annuities return a guaranteed income for the rest of the customer’s life, they are mainly backed by low-risk gilts and corporate bonds. Gilts are considered to have no risk while corporate bonds tend to create a better return, but carry increased risk as the company issuing the bond may become insolvent.
Annuity providers must hold reserves for expected defaults of corporate bonds. These reserves come from the extra expected yield to be gained by buying the corporate bond rather than the gilt. This is known as the credit spread, which is made up of a liquidity obligation and a default obligation. At the moment annuity providers typically reserve 25% – 50% of credit spread for corporate bond defaults.
So why the fall in annuity rates?
Solvency II affects the amount of reserves needed for potential defaults of any underlying investment that is not deemed to be 100% risk free – in other words, an allowance for the risk of corporate bonds defaulting.
When the Solvency II rules were first announced, commentators predicted that annuity rates would fall by as much as 20%. This was because the rules stated that 100% of the credit spread must be reserved for default. So, given that it is currently 25% to 50%, the impact on annuities was going to be significant.
Following political lobbying by several European governments including the UK, the rules have been changed to allow for different types of product. This has improved things slightly for annuities.
The following simplified example shows how the rules would currently affect pricing if they were implemented today. This example assumes the annuity provider is currently holding 40% of the credit spread for defaults.
So in effect, Solvency II will mean an increase in the default allowance from 40% to 68%. This causes a fall in yield from 5.25% to 4.55%. Using a rule of thumb that a change in yield leads to approximately 10 to 12 times the change in annuity rates, this would reduce rates by approximately 7% to 9%.
Annuity rates will further be affected by a change in requirement to hold increased solvency capital. Solvency capital is an additional buffer held in addition to the normal policy reserves that are set aside to make annuity payments and cover expenses. This buffer helps protect customer’s benefits in the event of a threat to the solvency of the fund, for example through a serious market crash. Holding this money represents a cost and this further reduces annuity rates.
Do I have to take action now?
The good news is that only new business after 1 January 2013 will be subject to the new rules so there is likely to be no impact of Solvency II changes until the date the rules come into force. It is important to note that neither the implementation date nor the rules themselves are set in stone.
However, it is not necessarily safe to assume there will be a ‘buy now while stocks last’ on 31 December 2012 scenario. Providers may start adjusting before the rules are in force, so think ahead.
You should also be considering whether a level conventional annuity supported by a low yielding asset class is the right decision for your client in the longer term, bearing in mind that there are other factors such as increased longevity pushing annuity rates south.
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