BLOG - A Small Earthquake
Rob Davies, Fund Manager VT Maven Smart Dividend UK Fund
Now and again governments make seemingly routine announcements that turn out to have enormous consequences. Whilst it is early days, it is likely that one such event occurred at the last budget, when the Chancellor announced that the compulsory purchase of annuities is to be abolished. That statement attracted a great deal of attention at the time from the financial press but it is probable that it will have much larger consequences for the economy as a whole.
An annuity is a promise from an institution, the annuity provider, to pay an income for life to someone who invests their pension fund, but the investor no longer owns or controls the capital invested. The provider doesn’t however know how long the investor will live, or what capital markets will offer as income over that period. It can generally do two things to reduce its risk when calculating the level of income it can pay. Its actuaries can make an informed calculation on the investor’s likely longevity, which will give a fair idea of how long its liability will last. It can also guarantee an income stream by buying gilts that match the expected lifespan of the investor, the income from which, together with the gradual return of capital, will constitute the cash flow it pays as an annuity.
Although annuities have been around for a long time it is only in recent years that they have become of interest to the general population. The gradual demise of workplace pensions that promised a defined annual payment based on years of service is now a rare and precious thing. Increasing average life expectancy and the unwillingness of companies to write a blank cheque to cover an unknown liability has effectively killed them off.
Instead the responsibility has been increasingly transferred to individuals to make their own arrangements, by saving enough money in a fund to buy their own pension, an annuity, at retirement. The scale of the task should not be underestimated. One way of quantifying the challenge is to look at the typical value of civil servant pensions from the Government Actuaries Department, which estimates that, for example, a 50 year old policeman has a pension pot equivalent to £600,000. To buy an income of £7,000/pa a healthy 65 year old single male needs about £100,000. The reason the annual income is so low is that Quantitative Easing has driven interest rates down to such historically low levels that a large amount of capital is required to purchase even a modest income, even with the return of capital. Ten-year gilts currently only offer a yield of 2.7%, which largely determines the level of the annuity income available.
By eliminating the obligation to buy an annuity with a pension fund, the Government has made it possible for individuals to either defer annuity purchase altogether if, for example, they can rely on other sources of income, or to invest in a different asset class that has the potential to give higher returns as well as keeping ownership of the capital. The respected Barclays Equity Gilt Study tells us that equities have given higher return than gilts for 88% of all eighteen year periods since 1899. Since the Government Actuary Department estimates that a 65 year old male now has a life expectancy of a further 22 years (or 24.5 years for a female) that looks a fair match. In addition equities are currently yielding a lot more than gilts so it seems likely that an investor would get more income and a better total return by investing in equities.
Life assurance companies hold 66% of the £1.4 trillion of UK debt currently in issue, much of that to back annuity payments. No one is suggesting that market will disappear, but there are suggestions that the current £12 billion of annual sales of annuities could shrink by up to 25%.
Where that money will go instead is the big unknown. Buy- to-let property investment is one likely home; though that requires active management and/or additional costs, so UK equities seems to be an attractive alternative. These companies, many of which have considerable international activities, currently yield 4% as an asset class.
This significant change to the pensions and annuity market would seem to indicate the Government’s confidence in the economy, if it can contemplate losing a large and reliable inflow into the UK debt market. Although any change in asset allocation will take a long time to execute, UK equities markets look set to benefit from such a switch. In total UK equities are worth £2.2 trillion so they are well able to absorb these cash flows.