The recovery in gilts yields is welcome after a multi-year yield drought. Yields collapsed after the global financial crisis following the central banks’ policy response of a near zero interest rate policy to help patch up the financial damage.
The decline in gilts yields necessarily triggered a decline in annuity rates. Why? Insurers who are promising to pay a lifelong income (an annuity), have to ensure they can fund that promise by holding safe, income-generating assets.
At its simplest, insurers invest in gilts and investment grade bonds to receive a regular income which they can use to fund the regular payments to annuity-holders for life.
So when gilts yields were very low, all bond yields were low, so there was less income coming into insurers’ pooled assets for them to pay out to their annuitants. That’s why gilt yields impact not only corporate bond yields (whose risk premium to gilts is known as its “spread”), but annuity rates too.
Why are annuity rates higher than yields?
Annuity rates are typically higher than gilt yields for one simple reason.
Annuities represent the return of your capital and returns, not just an income yield.
Annuity rates reflect the payments made for life in exchange for your capital. Gilt yields represent the “just” income received relative to the capital.
That’s why annuity rates are higher than yields, and get higher the shorter the time-frame.
If life expectancy is short, that time-horizon is short, so payments you receive to get back your capital are higher.
If life expectancy is long, that time-horizon is long, so payments you receive to get back your capital are lower.
Hence the less healthy you are (impaired annuities) or older you are (the less long you have to live), the higher the annuity rate.
Are annuities an asset class?
Technically no. When you invest in an asset class, you own that asset. When you buy an annuity you exchange your capital for the promise (guarantee) of an income until your death to be paid by the insurer. Annuities are a form of insurance (specifically “longevity insurance”) policy.
Are annuities a replacement for bonds?
No. Bonds pay you interest and return your capital at the end (at maturity). Their cashflows are the mirror image of an “interest only mortgage”.
Annuities return your capital as income, with no capital to pay at the end (at death). Their cashflows are the mirror image of a repayment mortgage whilst you are alive.
More importantly, bonds are sensitive to interest rates all the time. Annuities reflect the interest rates on the day you buy them and are fixed for the rest of your life. So if you bought an annuity two years ago when rates were record low, you locked in a worse deal than if you bought one today. We call the risk of converting all or substantial parts of your capital into an annuity at a given point in time “conversion risk”.
Clients (and their advisers) are highly focused on when, what level and how long to fix their mortgage rates. As a mortgage-in-reverse (thanks to Billy Burrows for this description), the same should be true for annuity rates.
