Defined contribution scheme… appropriate investment strategy is to … switch into bonds which match annuity prices closer to retirement”. 1) Which annuity should we try to match? 2) Why should we match annuity prices?
The key here is to realise that annuities are priced by discounting their future cashflows, and that the discount rates used are those implied by prices in the current bond market. By switching the pension fund into bonds this more closely matches the assets used to value the annuity. Therefore if bond prices fall just before retirement the value of the pension fund decreases, but annuity rates improve (because bond yields have increased) and so income in retirement remains (approximately!) the same. If the pension fund was invested only in equities and those prices fell just before retirement, the pensioner then has less with which to purchase an annuity (whose rates haven't changed).
