The average annuity-hedging fund has fallen by 38% so far in 2022…and has fallen by 5% since the mini-budget.
This market holds £9bn of pension savers’ assets. Annuity rates have risen this year, but nowadays only one in 10 pension savers buys an annuity.
These ordinary pension savers aren’t in line for a bailout from the Bank of England, though the FCA is planning to introduce default funds in individual pensions which will be expected to include ‘lifestyling’ in the design .
Laith Khalaf, Head of Investment Analysis at AJ Bell, said: “Back in February we issued a note warning that older pension savers could be sleepwalking into a bond market nightmare, because of exposure to annuity-hedging funds. Unfortunately, that nightmare has now become a reality. The average annuity-hedging fund has fallen in value by 38% this year and has sunk by 5% in the short space of time since the mini-budget, thanks to the ensuing sell-off in UK gilts (data from Morningstar to 4th October 2022). These funds are typically provided by insurance companies and invest in long dated bonds to hedge investors against movements in annuity rates. Even after this year’s steep price falls, they still account for £9 billion of pension savers’ money.
Source: Morningstar total return 31/12/21 to 30/09/22
“Annuity rates have indeed shot up this year, as some recompense for pension savers opting for an annuity at retirement. But since the pension freedoms were introduced in 2015, only about one in ten pension savers now buys an annuity, with the remainder keeping their pension fund invested or simply drawing it all out in cash. Many investors will therefore now simply be sitting on much smaller pensions than they were at the beginning of the year, as a result of the bond market sell-off. And the rise in annuity rates will be cold comfort to those who have no intention of buying an annuity.
Source: FCA
“The calamity of the sharp drop in annuity hedging funds is twofold. Pension savers are shifted into these funds just as they are about to retire, so have little or no time to rebuild their pension savings after sustaining losses. What’s more, many of them probably won’t even know the switch to an annuity hedging fund is happening. These strategies were commonplace amongst workplace pension defaults of the nineties and noughties, and in individual Stakeholder pension plans too. Savers in these schemes were never encouraged to engage with their pension investments, on the basis it’s all taken care of for them.”
How lifestyling works
“Many older defined contribution pension plans will automatically shift investors into these annuity hedging funds as they approach retirement, in a process known as lifestyling. The strategy is designed to reduce retirement income volatility for pension savers because annuity hedging funds invest in long dated bonds, whose yield plays a major part in determining annuity rates. If annuity rates go down, their annuity-hedging fund goes up, and vice versa.
“Investors in lifestyling strategies would be unlikely to have felt the full force of the 38% drop in annuity hedging funds, because they are gradually shifted into them, and there is usually a cash element too (see example below). But those within their last year before retirement could have 60% or more of their pension invested in an annuity hedging fund, so a 38% fall would translate into a hit of around 23% to their overall pension value. Those who are further away from their retirement date will have suffered less, though they are still be invested in a strategy that’s exposed to the bond market, and may not be appropriate for them if they’re not planning on buying an annuity.
Source: AJ Bell
“The obsolete nature of these lifestyling strategies since the pension freedoms has been disguised by the flattering effect of ultra-loose monetary policy. Low interest rates have driven up bond prices, and with them the value of annuity-hedging funds (see chart below). No investor is going to complain if their pension fund is going up as they approach retirement, whether they’re buying an annuity or not. That’s not the case if their pension fund has plunged just as they are about to draw on it. That’s the situation we’re now facing, as monetary policy has rapidly changed direction and the latest round of fiscal policy has added further fuel to the bond fire.”
Source: Morningstar total return 30/09/17 to 30/09/22
Annuity hedging fund investors won’t get a bailout
“The recent fall in bond prices prompted by the Chancellor’s mini-budget has added insult to injury, as well as a bit more injury to boot. The bond market appears to have since stabilised somewhat, but with the Bank of England providing emergency life support, it’s not entirely clear if we’re seeing an honest market price for government debt.
“The irony is that the central bank’s bailout was prompted by the investment strategy of defined benefit pensions. In other words, professional, institutional investors, where everyday members of the scheme are protected from investment risk by a guarantee from their employer or ex-employer. By contrast, those invested in annuity-hedging funds aren’t in line for any bailout from the Bank of England, they’re simply going to have to wear their losses. We estimated that collectively, these losses are somewhere in the region of £5 billion this year (based on Morningstar fund size and performance data).
“It’s possible the worst is now over, and gilt prices have found a new equilibrium. But despite the steep bond price falls we’ve seen this year, inflation and rising interest rates are still a clear and present danger to the bond market. Particularly when combined with the additional supply coming to the market to fund the government’s latest tax cuts and energy price freeze, and the £80 billion unwinding of QE planned by the Bank of England over the next year. We certainly shouldn’t expect gilt prices to simply flip back up to where they were a year ago, when the benchmark 10-year gilt yield sat at a breezy 1% (it now stands at around 4%).”
The flaw of default investment strategies
“The plight that lifestyled pension schemes find themselves in today really exposes the folly of relying on defaults which put in place an automatic investment strategy many years, or even decades, before that strategy starts to be executed. During this time there can clearly be changes in capital markets, consumer behaviour or regulation, which can render such strategies obsolete and potentially dangerous.
“The FCA is currently consulting on introducing default funds for individual pension schemes, including SIPPs, and has said that it would expect providers to build lifestyling into the design of such funds to de-risk pension portfolios in the approach to retirement. It’s very unlikely that providers building such a de-risking strategy today would use annuity-hedging funds, given the fact so few people are buying an annuity with their pension pot. But that doesn’t mean that contemporary strategies will be future proof against the changes in pensions and markets we will inevitably see in the 2030s, 2040s and beyond, when these default choices will start to kick in for today’s younger savers.
“It might instead be preferable to confront the issue of pension apathy head on through communication and engagement, rather than trying to sidestep it with default strategies that are undoubtedly well-intentioned, but still often found wanting. Those who suggest that ordinary folks will never be able to get their heads around pension saving and investment might reflect on the fact that millions of people take on hundreds of thousands of pounds worth of housing debt, without a default mortgage product in sight.”