An article on a seemingly obscure piece of European legislation might not be at the top of your reading agenda, however if you are thinking of buying an Annuity in the near future then read on, Solvency II could significantly affect you.

Solvency II rules are currently expected to be in force on 1 January 2013. The rules are believed to be close to final and are designed to ensure all providers can meet their financial obligations to their customers, avoiding future crises such as the Equitable Life scandal. Furthermore they should give regulators an early warning if provider solvency levels become depleted.

Many industry experts believe the new rules will lead to a reduction in Annuity rates due to the constraints it will place on the companies who offer Annuities. In this article we look at why this might be the case and what if any action you could take. Firstly we need to start with the basics:

How annuity pricing works

To ensure annuities return a guaranteed income for the rest of the owner’s life, they are mainly backed by low-risk Gilts and Corporate Bonds. Gilts are considered to have no risk while Corporate Bonds tend to create a better return, but carry increased risk as the company issuing the Bond may become insolvent.

Annuity providers must hold reserves for expected defaults of Corporate Bonds. These reserves come from the extra expected yield to be gained by buying the Corporate Bond rather than the Gilt. This is known as the Credit Spread, which is made up of a liquidity obligation and a default obligation. At the moment annuity providers typically reserve 25% – 50% of credit spread for Corporate Bond defaults.
So, why the fall in annuity rates?

Solvency II affects the amount of reserves needed for potential defaults of any underlying investment that is not deemed to be 100% risk free – in other words, an allowance for the risk of Corporate Bonds defaulting.

When the Solvency II rules were first announced, commentators predicted that annuity rates would fall by as much as 20%. This was because the rules stated that 100% of the credit spread must be reserved for default. So, given that it is currently 25% to 50%, the impact on annuities was going to be significant.

Following political lobbying by several European governments including the UK, the rules have been changed to;…eh? this has improved things slightly for annuities.

The following simplified example, provided to us by MGM Assurance, shows how the rules would currently impact on pricing if they were implemented today. This example assumes the annuity provider is currently holding 40% of the credit spread for defaults.

So in effect, Solvency II will mean an increase in the default allowance from 40% to 68%. This causes a fall in yield from 5.25% to 4.55%. Using a rule of thumb that a change in yield leads to approximately 10 to 12 times the change in annuity rates, this would reduce Annuity rates by approximately 7% to 9%.

Pre Solvency II pricing Post Solvency II pricing
Gilt yields 3.75% 3.75%
Corporate bond yields 6.25% 6.25%
Credit spread 2.50% 2.50%
Illiquidity premium N/A 0.80%
Default allowance 1.00% (based on 40% of spread) 1.70% (2.50% less 0.80% and 68% of spread)
Yield net of defaults 5.25% 4.55%

Do I have to take action now?

The good news is that only new business after 1 January 2013 will be subject to the new rules so there is likely to be no impact of Solvency II changes until the date the rules come into force. It’s also important to note that neither the implementation date nor the rules themselves are set in stone.

However, whilst in theory providers need to do nothing until then, most will have to adjust their books and may pull back pricing gradually over the next few years to strengthen their reserves in anticipation of 2013. This may have the effect of reducing Annuity rates sooner than January 2013.

What other options do I have?

When or even whether, to purchase an Annuity is probably one of the hardest financial decisions you will ever make and Solvency II will certainly not make it any easier.

It’s safe to say that if you need income now, have no other method to produce that income and are attracted to the guarantees and simplicity offered by a Lifetime Annuity then you probably have no other choice other than to move ahead along that route.

However there are other options available if you wish to delay the date at which you purchase a Lifetime Annuity.

A Fixed Term Annuity allows you to purchase an Annuity for a specific period of time and therefore gives you an income. You set the term, generally three years or longer, and at the end of your chosen term a fund will remain which can then be used to purchase either a further Fixed Term Annuity or a Lifetime Annuity. More information about Fixed Term Annuities can be found by clicking here.

You could also consider Income Drawdown, this is certainly a more complex option than an Annuity and can carry significant investment risk, however for the right individual it can be an appropriate option. More information about Income Drawdown can be found by clicking here.

Each option carries some degree of risk, even with a Lifetime Annuity you run the risk of buying at the wrong time, we would therefore urge you to take advice on all the options available to you. Take time to consider the advantages and disadvantages of each and then make an informed decision.

Solvency II is just one additional piece of a very complex jigsaw, we would always recommend that you take advice when considering how to turn your pension into income, it is after all a decision that you could be stuck with for a very long time.

If you wish to discuss your circumstances with one of our advisers then please feel free to call us on 0115 933 8433 or email info@investmentsense.co.uk we will be only too pleased to help.