Can i ask why the cost of the guarantee on vesting annuities necessarily increases under the stress? I thought that for annuities, companies would typically try and back them with corporate bonds. Reason being that if they can suitably match the cashflows then they can get a liquidity premium benefit. If corporate bond yield has increased (and this is mostly driven by a liquidity issue and not default effect), then couldn't this offset the decrease in the risk free yield and hence increase the overall discount rate for the annuity cashflows? If so, wouldnt this decrease the cost of the annuity guarantee? Also factoring in that the value of the fund is also likely to decrease if its backed by equities?
Hi - yes I agree, this wouldn't necessarily be the case as there are various factors coming into play here. (Although it is probably a stretch too far to assume that the 2% credit spread widening would be mostly liquidity rather than default risk driven.) The solution does say that the increase is 'likely' rather than definite. What was important was to demonstrate recognition that the interest rate fall would in itself increase the cost of the guaranteed annuity option. And yes, the fund size itself would also be relevant. We might have the maturity value (asset share) falling if held in equities or corporate bonds, but increasing if held in government bonds or perhaps overseas bonds (given the currency change). Where there aren't necessarily definitive outcomes, by all means describe alternatives where valid and where there are sufficient marks available - but make sure that you include the more obvious or straightforward relationships too, and try to avoid drilling down too far into one particular avenue of thought.
