Legislation: Muddying the waters

Andrew Tully assesses 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.

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.

Impact of Solvency II

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.