How Solvency II will affect the annuity market

Andrew Tully discusses the potential impact of Solvency II

The retirement market has evolved rapidly over the past few years, with a variety of new products appearing to meet increasing life expectancy and consumers' desire for more flexibility and control. But soon a regulatory time-bomb, in the form of Solvency II, will muddy the retirement waters. This constant change confirms the need for people to take independent advice, but anyone giving advice needs to be aware of the implications of buying an annuity now or waiting until a later date.

The Solvency II rules come into force on 1 January 2013, and are designed to make sure all providers can meet their financial obligations to their customers, hopefully avoiding future pension crises such as the Equitable Life scandal.

To understand the impact Solvency II will have on the annuity market, we need to briefly consider how the market currently works. Historically, annuities were invested in government gilts. While the return was relatively low, the investor could be confident of receiving payments. Since the 1990s, however, more annuity funds have been invested in corporate bonds to take advantage of higher returns, allowing providers to offer better annuity rates.

What are the risks?
But there is a risk these companies offering bonds can become insolvent, so providers need to set aside part of the investment return to cover this default risk. The extra investment yield which compensates investors for taking on the default risk is known as the credit spread, and annuity providers typically reserve 25% to 50% of the credit spread to cover corporate bond defaults, although this varies depending upon the financial strength of the company offering the bonds.

Solvency II increases the amount of reserves which are needed to cover this default risk. In simple terms, this means insurance companies either have to invest in risk-free assets (gilts) or hold higher capital reserves than they currently do. When the Solvency II rules were first announced, the rules proposed that 100% of the credit spread must be reserved to cover defaults. This was effectively removing any additional investment return which investing in corporate bonds could provide. If it had gone ahead the impact on annuity pricing would have been dramatic.

Following lobbying by several European governments, including the UK, the rules have been relaxed, slightly improving the position for annuities. While reserves will have to increase substantially - perhaps to around 70% of the credit spread - investing in corporate bonds may still yield greater returns than gilts, allowing providers to offer better rates than through risk-free investing.

Solvency II also introduces a ‘stress test' for mortality risk, meaning providers need to hold greater reserves in case their annuity book lives substantially longer, on average, than expected.

Possible impact
Both proposals have a clear impact on annuity pricing, with suggestions that annuity rates will fall by approximately 10%. Add in the impact of the EU gender directive and continuing increases in life expectancy, and it seems clear that annuity rates will continue the downward trend we have seen for the last decade.
The good news is Solvency II only affects new annuities set up from January 2013. It's important to note that neither the implementation date nor the rules themselves are completely set in stone, although the details are close to being final.

However, while in theory providers need do nothing until 2013, most may start to alter pricing gradually over the next 18 months to strengthen their reserves in anticipation of these changes.

Conventional annuities continue to be used by the majority of retirees, and once Solvency II is introduced these will be supported by a very low yielding investment. So advisers need to decide if this is the right decision for their clients in the longer term, taking into account their circumstances and external factors such as inflation. Fixed term annuities are not hit as heavily as the annuity only covers a finite period. But it can be argued that temporary annuities simply defer the impact for a short period, when annuity rates may be worse.

When advising clients today, the fact that annuity rates will be lower in future needs to be taken into account. But the key, as always, is focussing on the best solution for the client given their personal circumstances, and that should not be over-ridden by any knee-jerk reaction to lock into conventional annuity rates before they fall. The focus is helping people make suitably informed decisions, whether that is shopping around for the best annuity, or choosing drawdown or an asset backed annuity.

Andrew Tully is pensions technical manager at MGM Advantage