Inflation protection – a capacity crunch over the horizon?

John O’Malley contributed to the writing of this blog post

With one of the leading insurers seeing its sales of retail annuities drop by half in the first six months of 2014, the new retirement freedoms for DC members have seen many insurers increasing their attention on the buy-in and buy-out market.

A record volume of bulk annuity business has been transacted during 2014, with deals totalling around £12bn having been announced in the year to date. Whilst this is not as a direct consequence of the announcement of Budget 2014, the Budget has helped to support competitive pricing and we anticipate this £10bn-plus level of annual business could continue into 2015 and beyond. As familiar faces that have been active in the retail annuity market focus more resources towards the de-risking of defined benefit (DB) schemes, they may also be joined by some new faces who have been prompted to enter the market. For trustees and sponsors looking to transact in the next few years, this represents a welcome development.


With greater insurer resources being directed to the sector, this would be expected to lead to more supply pressure on pricing but equally this may well be offset by the ever-increasing demand from schemes to de-risk. As ever the appetite of trustees and sponsors to transact will ultimately depend on affordability.

It is the underlying market conditions that will largely dictate the opportunities and challenges that pension scheme trustees and employers are faced with. At the time of writing gilt yields have sunk to near record lows, tending to increase scheme liabilities. The outlook for yields remains uncertain but yields could remain low for some time.

A recent joint report by Fathom Consulting and Pension Insurance Corporation (PIC) has looked to model a particular UK economic scenario over the next decade and examine how this could potentially affect schemes and the bulk annuity market. Based on the Office for Budget Responsibility’s (OBR) July 2014 expectation for future UK economic growth, the report predicts a considerable improvement in the aggregate scheme funding level with the aggregate level being restored to full funding by 2019. By 2021, the report predicts that over half of all schemes may reach a funding level of 125%, taken to be equivalent to the amount necessary for a full buy-out of the liabilities with an insurer.

The analysis by Fathom and PIC is based on a relatively positive outlook for pension schemes. In particular, the authors acknowledge that their forecast for the normalisation of gilt yields does not reflect the future rates currently priced in by the market – their model predicts the weighted average of yields on all conventional gilts reaching 5% in over a decade. This is an assumption which should be treated with caution, and it is interesting to note that their ‘risk scenario’ (whereby nominal yields rise only very gradually towards 3%) would lead to far less favourable outcomes for schemes.

Market capacity

The analysis further suggests that, based on the specific scenario adopted for the progression of UK markets in future, pension scheme trustees and employers could be faced with a capacity crunch relating to a shortage of index-linked gilts with a cumulative shortfall equating to £500 billion.

Under this scenario, and assuming no change in the relative proportions of nominal and index-linked debt issued by the UK government (the proportion of ‘linkers’ is currently around 25% of the total debt issued), this would leave schemes struggling to meet the anticipated desire for inflation protection as they look to lock in an improvement in scheme funding levels. A shortage of index-linked gilts would also impact on insurers providing inflation-linked annuities, and therefore impact on the buy-in and buy-out market.

De-risking options

Despite the general uncertainty, the new world for annuity providers as a result of the DC flexibilities under the Budget 2014 has helped drive competition in the bulk annuity market which may lead to opportunities in the short-term.

If the mitigation of inflation risk is a concern which may arise, then there are some other options available for trustees and employers – for example, liability management processes such as a pension increase exchange or transfer value exercise. In particular, offering an 'at retirement' option to members may be an attractive way of reducing risk over time, especially where access to the DC flexibilities provides additional appeal to members.

As always, it pays for schemes to be well prepared and in a position to take advantage of de-risking opportunities as they emerge – either on the liability or asset side. Monitoring of the market position is an integral part of this.

Key actions for trustees and employers looking to de-risk:

  1. understand the risks in the scheme
  2. monitor affordability of buy-in or buy-out
  3. consider liability management exercises