UK annuity reforms may squeeze insurers' appetite for illiquid assets

Insurers' appetite for investments in infrastructure and property is expected to fall following announcements in the UK Budget that are seen as damaging to their annuity business

The UK government's plans to reform the pensions market will reduce annuity providers' risk appetite for long-dated, illiquid assets, say market participants.

Chancellor Osborne announced a series of changes in his Budget speech on 19 March designed to give workers enrolled in a defined contribution pension scheme greater control over their money on retirement.

The flagship announcement was the scrapping of the 55% tax levied on retirees who opt to withdraw their entire pension pot at retirement age. It is hoped this will incentivise more people to shop around for retirement income solutions besides annuities.

Currently, 75% of members of defined contribution schemes elect to purchase an annuity with their pension pot, according to government estimates.

If the retail annuity market shrinks in response to the changes, insurers' appetite for long-term investments will reduce, say bankers.

Paul Fulcher, managing director, ALM structuring at Nomura in London, says: "Most insurers when they start investing in new asset classes use the premiums that flow in from new business. If annuity premium flows reduce, the amount insurers will invest in long-dated assets will diminish".

The UK government estimates £11 billion is invested by individuals each year into annuities. Of this, 60% is invested by insurers in corporate bonds or equivalents, and the remainder in a mix of assets, including infrastructure assets, mortgages, commercial real estate and social housing.

Fulcher says allocations to these alternatives will suffer most if annuity sales decline.

"In December last year, six UK insurers [Aviva, Friends Life, Legal & General, Prudential, Scottish Widows and Standard Life] pledged £25 billion to infrastructure investments. That money was coming from new annuity business. This will not be viable in the future because the Chancellor is taking away the money to fund such schemes," says Fulcher.

Asset managers are more sanguine about the effects the pension reforms will have on long-term investing. Patrick Liedtke, head of the financial institutions group for Europe, the Middle East and Africa at BlackRock in London, says: "Insurers see these alternative long-term assets as an opportunity for them to have a broader exposure to risk and diversify their portfolios, and this need does not go away. So while the growth path might change, the desire to allocate to these asset classes will not disappear".

A change to the annuity landscape, and a subsequent push by insurers to offer more flexible products, would also reduce the importance of the Solvency II matching adjustment to firms. This rewards firms that match long-term liabilities with long-term assets in the form of an uplift to the rate at which they must discount liabilities.

"If insurers are forced to offer products that don't qualify for the matching adjustment, that takes away another thing that incentivises them to invest in long-dated illiquid assets," says Fulcher.

Others say it is too early to gauge the impact of the measures on insurers' investment appetites. Kim Durniat, partner and head of life insurance consulting at actuarial consultancy Barnett Waddingham in London, says: "How much the annuity market will be affected is debatable because many people still need and want protection against their own longevity risk, and some will not want to manage their own investments in later life.

"When it comes to investments in long-term assets, individuals taking control of their own pension pots may well choose to invest in these anyway, so demand may not suffer too much."

Consultants say annuity writers have the option of expanding their activities in the bulk purchase annuity market to make up for the shortfall in retail business.

James Mullins, partner and head of buy-outs at Hymans Robertson, says: "Annuity writers already active in the BPA space will accelerate their activities insuring defined benefit schemes, and any market participant that writes decent volumes of retail annuities are obvious candidates to get involved in the bulk annuity market as well.

"This is good news for defined benefit schemes because the more competition there is the better the pricing will be," he adds.

A spokesperson for Legal & General insists they have the flexibility to dial up or down business across the bulk, individual and longevity insurance lines to compensate for market changes. New business annuity flows for the insurer, as of the second quarter 2014, consisted of 70% bulk purchases and 30% individual annuities.