Qsn April 2005 P2 question 6 ii

[nyaman]

I understand that annuity rates vary depending on bond yields but I don't understand why if they fall the guarantee will bite. Can someone enlighten me.

 

[Hemant Rupani]

annuity rates fall - return will be lower - more chances that returns are lower than guaranteed - once annuity rate falls that returns are lower than the guarantee - guarantee will bite.

 

[Steve Hales]

Bonds are typically used to back annuities. If bond yields are high then bond prices are low, meaning that it's cheap to purchase the bonds required to fund an annuity. If a minimum level of annuity is guaranteed, then the provider is essentially betting that bond prices will remain low - and whilst this is the case the guarantee doesn't bite. When bond yields fall however, the bond prices increase making annuities more expensive to provide. If this causes the guarantee to bite, then it will cost the provider more to offer the promised annuity terms.

 

[Frances]

Could someone explain to me the relationship between annuity rates and bond yields? Perhaps I am missing something here! I don't quite follow why if bond yields fall, annuity rates will also fall. Is this because bonds back annuities?

Thanks,

Fran

 

[XChen]

Yes bond are used to back annuity. If annuity rates paid are higher than bond yield, it would not be sustainable for product provider

 

[Frances]

Thanks! I think the penny's dropped now was definitely over complicating it!