This is one of a series of 8 chapters which we hope will stimulate thought around the difficult issues that people may face while investing in retirement. Spire Platform Solutions does not provide advice and does not advocate any particular investment solutions.
For over a decade, insurance companies have invested much of the money they receive from annuity sales into Corporate Bonds. This has led a number of people to ask whether you might simply cut out the insurer and get a similar, or maybe better, return by investing directly in Corporate Bonds, or in Corporate Bond funds.
Higher returns may well be available from Corporate Bonds, but it’s important to understand the higher risks that are associated with direct investment in bonds or bond funds, so that an informed decision can be made as to whether these risks are appropriate for each individual.
Corporate bonds are usually of short duration. Even if they are bought at the new issue stage, they probably only offer a period of five to seven years until maturity, as that’s about as far ahead as most companies plan.
At the end of their term they will deliver a large capital payment back to the purchaser, and this needs to be re-invested on terms that are not known at outset. This re-investment risk may well occur four or five times during the lifetime of a pensioner relying on Corporate Bonds for their retirement income.
(The reader may wonder how annuity providers handle this when they use Corporate Bonds, and for an answer you have to enter the murky world of interest rate swaps, which are available to institutions but not retail investors.)
When a Corporate Bond is issued, it is accompanied by a prospectus which typically runs to over 100 pages. Buried in here are the flexibilities that the issuing company has retained, which may well upset the savers carefully laid plans. For example, holders of Helical Bar’s 6% 2020 bond found that their investment was repaid two years early. And holders of Aviva’s 8.375% Irredeemable Preference Shares were stunned last year when Aviva announced that they might have a right to cancel them at par, despite the market price being much higher.
We can’t fail to hear the news when a big company like Carillion collapses unexpectedly, and investors lose everything. But defaults for bondholders can also occur even when companies survive and continue to trade normally. The Co-operative Bank continues to provide High Street banking services to the public, but holders of its Corporate Bonds lost around half their capital when they were forcibly bought out in the rescue deal. And holders of Manchester Building Society’s 6.75% PIBS, once a higher income staple for pensioners in the know, have received no coupon payments since April 2016 on account of the Society’s financial position. Meanwhile ordinary savers using that Building Society’s over the counter services are completely unaffected.
Corporate Bonds can be illiquid, and their quoted stock market prices are often only for very small trades. A Corporate Bond fund seeking to make a major exit may find the price much lower than the official stock exchange prices, and that only applies if they can sell them at all.
We need to remember that funds are fine when they have a good balance of buyers and sellers but that holders can get badly damaged if circumstances drive the trades all one way.
Only about 10% of your client base will live exactly to their life expectancy, give or take a year or so. Half will live longer, and a portion of those much longer than predicted.
The Corporate Bond investments may be depleted or even exhausted before death, whereas an annuity will continue for the whole of life.
The other side of this coin is early death, where the Corporate Bond can be passed to beneficiaries but a single life annuity will cease. This worry can however be ameliorated by choosing an annuity with a high death benefit in the early years, to avoid this very natural fear that the money spent on an annuity could be wasted in the sad event of premature death.
So how do insurers make these risks go away when they construct an annuity for retirement income provision? The risks themselves don’t disappear of course. What happens is that the insurer takes them onto its own Balance Sheet and all the pensioner is exposed to is the single covenant risk of the insurer itself going under. And even that risk is wiped away by the Financial Services Compensation Scheme which guarantees that, in the highly unlikely event of an insurer failing, FSCS will make all payments due under the annuity, right through to death and with no upper limit.
By Adrian Boulding - Chief Innovation Officer at Spire Platform Solutions.