UK long-dated government bond yields are the highest they have been for almost 30 years as investors offload holdings amid growing worries about the public finances.
The sell-off in gilts raises borrowing costs for the government, piling pressure on chancellor Rachel Reeves to get a grip at the next Budget. But one group benefiting from the higher gilt yields are retirees buying annuities.
Annuity rates have risen dramatically in the past few years. Since July 2020, pension provider Standard Life calculates that average annuity rates have increased by just under 3 percentage points or 63 per cent.
Gilt yields, which have an inverse relationship with prices, are linked to annuity rates because annuity providers buy long-term government bonds to back these income promises.
Last month, a 65-year-old buying an annuity could secure a level, or non- escalating, annual income of £7,670 from a £100,000 investment, according to the life assurer’s annuity rates tracker. This compares with £4,710 in 2020. This sharp uptick in rates has reinvigorated the market with sales of annuities last year reaching £7bn — their highest level for a decade.
Advisers expect this year to be equally buoyant as more people look to the security of an annuity as it guarantees income for the remainder of the holder’s life, though inflation will eat into the income where retirees choose a non-escalating annuity option. Inflation-linked annuity options also exist, but the cost is a lower starting income.
This guarantee of income is unlike drawdown plans, where future retirement income is dependent on the performance of the underlying investments. If you take too high an income or investment performance is weak, your future income can fall.
“People are acutely aware that investing can be quite volatile, so annuity conversations are definitely coming back into the frame,” says Rebecca Williams, a chartered financial planner with wealth manager Rathbones.
Worries about volatile markets are particularly relevant today with the threat of more tax rises in the November Budget and fears for the global economy because of uncertainty over tariffs and wars in the Middle East and Ukraine.
Helen Morrissey, head of retirement analysis at investment platform Hargreaves Lansdown, says a “ballpark” annual withdrawal figure for income drawdown investors to maintain a sustainable income throughout their retirement is 4 per cent of the underlying fund value. However, this depends on the individual’s age, health and investment choices.
With annuity rates often running at nearly double this 4 per cent rate, growing numbers of wealthier people with larger pension funds have turned to annuities in recent years, she says.
In the first six months of this year, the average fund size used by Hargreaves Lansdown clients to purchase an annuity reached £162,729, compared with just £62,301 in the first six months of 2021.
But “it doesn’t have to be an all or nothing, one-way street decision”, says Gary Smith, partner at wealth manager Evelyn Partners.
“A client might say ‘We’re happy to use £250,000 of our pension pot to buy an £18,000 guaranteed annual income and leave another £250,000 in drawdown.’ So if inflation does go up, they have that flexibility to draw an additional income to top-up that fixed income that they’ve got.”
People who are a long way from retirement should also start thinking about their options, advisers say, not least because many pension plans have lifestyling programmes. These automatically switch your pension fund money into less volatile investments such as gilts in the years approaching retirement.
If your plan is eventually to purchase an annuity, lifestyling will normally aim to have 25 per cent of your fund in cash and the rest in gilts and fixed interest securities by your retirement date, says Smith. In contrast, if you’re aiming for income drawdown, lifestyling will allocate a greater proportion to equities, since drawdown investors tend to invest at least part of their fund in stocks and shares throughout their retirement years.
But despite higher gilt yields making annuities more attractive, there are considerable risks that investors need to be aware of. The impact of higher government bond yields is being felt beyond annuity buyers.
Most affected are UK fixed-income funds, which tend to suffer a fall in capital values as gilt prices fall when yields rise. In particular, corporate bond funds have been hit as rising gilt yields have depressed fund values.
Sterling-denominated corporate bond funds, which invest in longer dated bonds of more than five years to maturity, have lost 0.97 per cent annually on average with income reinvested over the past five years, according to financial services group Morningstar.
Further rises in yields also remain a concern, as investors start to lose patience with the UK government over its efforts to trim borrowing and cut its fiscal deficit, currently running at about 5 per cent.
The fact that some of the biggest moves in the UK government bond markets in recent years have been the result of fears over unchecked government spending highlights investor unease about the rise in public debt, which exceeds 100 per cent of economic output, or GDP.
This is the highest level since the early 1960s, as government spending during the financial crisis and the Covid-19 pandemic takes its toll.
“You’re seeing waning demand for government bonds and worries about debt sustainability given the high levels of borrowing and relatively large annual deficits from a number of countries,” says Isobel Lee, head of global bonds at fund manager Insight Investment.
Marcus Jennings, fixed-income strategist at fund manager Schroders, adds: “Unless we see a real change of tack from the Labour government’s response with respect to getting the deficit under control over a reasonable time horizon, then actually the path of least resistance is potentially [for yields to] rise a little bit further.”
This could force mortgage rates higher too, says Ray Boulger, senior mortgage technical manager at broker John Charcol, as “gilt yield movements [are] a good way of anticipating where mortgage rates will be”.
“Swap rates [lenders’ borrowing costs in the wholesale markets] are directly affected by gilt yields. So, if gilt yields and swap rates rise, mortgage rates tend to follow,” he explains.
For now, the jump in government bond yields is helping boost annuity rates. But should rising public debt lead to further rises in gilt yields, any benefits for retirees could be offset by falls in the value of fixed-income funds, higher mortgage rates or any weakness in the stock markets.