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EU ruling to slash UK annuities by 10 per cent

Will EU regulation eat away at annuity rates or could an interest rate rise act as investor's saving grace?
June 30, 2009

UK investors face the prospect of smaller retirement incomes because of an updated set of regulatory requirements for insurance firms that operate in the EU.

The proposed regulation, called Solvency II and scheduled for 2012, will force UK insurers to hold additional reserves against their annuity liabilities. This, says Tom McPhail, pensions expert at Hargreaves Lansdown, could see a drop in individual annuity rates of up to 10 per cent, leaving annuity investors with a significantly lower level of income.

“This EU legislation is bad news for anyone more than a couple of years away from retirement. It will drive down annuity rates and force investors to seek higher returns elsewhere. It is highly questionable whether UK investors will benefit from this additional layer of regulation,” says Mr McPhail.

Dr Ros Altmann, an independent pensions policy adviser, says that annuity rates are bound to worsen if insurance companies have to hold more prudent reserves. “So far, annuity providers have used corporate bonds and even asset-backed securities to back annuity books with less reliance on gilts. If they have to hold more in lower-yielding gilts then this must make annuities more expensive,” she adds.

Impact on UK insurers

The longer the expected lifespan of a company’s annuity business, the greater the reserving required. Insurers writing bulk buy-out business are expected to be most severely affected because they set up annuities for much younger members - the impact could reportedly be as much as 20 per cent. The individual annuity market is likely to be much less affected with 3 per cent to 10 per cent, the predicted reduction.

"Younger retiring investors who have a longer life expectancy and therefore require greater reserves, will see a proportionally bigger rate reduction than older investors," says Mr McPhail. Existing annuitants will not be impacted by the EU reserve requirements as their contracts are already in force.

Most UK insurers are arguing that they already have sufficient financial accounting rules in place and are lobbying for exemptions to the draft regulations, saying that the UK annuity and private pension market is more mature than most mainland European countries.

"Annuity companies have come through the stresses and strains of the last 12 months successfully, they argue that further reserving requirements will not provide any additional meaningful protection - it will simply mean lower incomes for British investors," says Mr McPhail.

He adds that an increase in reserving requirements may force consolidation among insurance companies as the cost of writing business goes up which could ultimately reduce competition in the UK market.

Impact on UK pensions investors

So, does Solvency II imply that those facing retirement should annuitise earlier rather than later? "Timing is difficult, given that Solvency II does not come in until 2012, and before then there will be conflicting pressures," says Dr Altmann.

While Solvency II and continuing improvements to life expectancy would push rates down, given upward pressures on interest rates, this could be overridden by inflation. “I believe interest rates are bound to rise over the next couple of years, which should, in theory, be good for annuity pricing and make them cheaper. However, as more and more defined-benefit schemes buy bulk annuities - especially for their pensioners - the volume in the market will be taken up more by bulk buy-outs or buy-ins and that could mean that pricing for individual defined-contribution pension pots will worsen," says Dr Altmann.

While many pensions experts foresee other retirement solutions such as investment-linked annuities, third-way annuities and drawdown becoming increasingly attractive, Dr Altmann says that on balance annuities probably offer reasonable value at the moment, and companies may look to widen their profit and risk margins after the credit crunch, however if interest rates do go up sharply then annuity rates could benefit in 2010. “My fear is that we are ignoring index-linked annuities and that piling into fixed-term annuities could prove dangerous if inflation picks up as I believe it will,” she adds.

For now, Mr McPhail says the best advice for investors is to shop around to ensure that they are getting the very best possible rates at retirement. “They have a right to the Open Market Option (OMO) - it costs nothing extra to use it and it can deliver an increased income for life,” he says.

Historically when people retired from work they simply took their pension from the employer or insurance company providing their pension scheme. Today, OMO acts as a ‘get out clause’ giving an individual the freedom to shop around for the best annuity deal.

Mr McPhail adds: "Ultimately, those investors who are further away from retirement should anticipate that rates may fall and this will mean that they have to save more money now to deliver the same level of retirement income in the future."