Annuity Risk

[LloydieW1990]

Please could somebody explain the penultimate paragraph on page 6 of chapter 40?

It essentially says that to mitigate the risk of annuity terms being worse than expected due to falls in bond yields, one should switch to bonds that back the annuities as retirement approaches. If bond yields falls, the cost of purchasing annuities will rise. However, this should be offset by a rise in the value of the retirement fund.

I'm struggling with the last two sentences. The value of the fund will rise but by a smaller amount than expected since bond yields are lower. Does the "cost of purchasing annuities" mean the cost relative to before the fall in bonds as the member now has less purchasing power than before? If so, why move to bonds at all close to retirement?

Huge thanks in advance

 

[Helen Evans]

Your thinking in your first paragraph is correct, ie insurers tend to hold bonds to back annuities, and we can protect ourselves against an increase in annuity prices by holding these bonds.

The reading says:
"If yields on these assets fall, the cost of purchasing annuities will rise", ie if the yield on bonds falls then annuities are more expensive to buy (than they were before the yield fell), since a larger single premium is needed to provide the same stream of pension payments if the insurer cannot achieve such a good level of return on its investments.

"However, this should be offset by a rise in the value of the retirement pension fund." If we invest our pension fund in the same bonds then if whilst we are holding the bonds there is such a fall in yield it will mean that the price of the bonds increases (given the inverse relationship between yield and price on a bond) and so we have a larger retirement fund. And this is what is needed to pay the higher premium to purchase the annuity, ie we are protected against the price rise.

I hope that helps