A new report has shown that annuity rates have halved over the last 15 years, not least because of falling gilt yields. This is clearly important for people retiring from defined contribution plans, but it is also important for defined benefit schemes and their sponsors.
The obvious reason for this is that bulk buyout prices are subject to the same forces as individual annuity rates, so securing benefits will be harder than it has been in the past. However, it is just as big an issue for pension schemes that have no intention of closing.
When benefits are accrued in a pension scheme, each additional year of pension earned can be thought of as a slice of deferred annuity. This means that if annuity rates are falling, the cost of future accrual to the sponsor is going up. What’s more, the longer duration of benefits for active members means that the sensitivity to interest rates is increased – if annuity rates have halved over the last 15 years (which the study says they have), then the cost of accrual will have more than doubled. There is some consolation for annuitants. If they invested in equities, then returns on these investments might have outweighted the increased cost of annuities. Even investing in bonds would neutralise the effect of falling yields (assets would rise as annuity rates fell). This is clearly not an option for firms – the cost is the cost and there is nothing to offset it.
This increase in the cost of defined benefit pension schemes seriously reduces the attractiveness of such arrangements to sponsors. A major rethink of pension scheme design is needed if defined benefit schemes are to survive in any form.