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Extreme bonds are hurting retirement plans

Ed Monk

Ed Monk - Fidelity Personal Investing

When the economic news looks uncertain, as it has recently, it’s the stock market that gets most attention.

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The FTSE 100 and S&P 500 are often taken as scoreboards for economic success, with sharp falls taken as a sign that we should worry. The bond markets tend to make fewer headlines.

Bonds are a complicated business to explain in a news bulletin, and even those people with investments in bonds may not truly understand the significance of price movements. But bond prices have many knock-on effects - not just for the value of investment portfolios, but also for the pricing of other financial instruments that are underpinned by bonds.

These include annuities, the products which have traditionally been used to turn a pot of money inside a pension into an income in retirement. You hand over your retirement savings and an annuity company will agree to pay you a percentage of them back to you each and every year for life. That percentage is determined in large part by the market rate for bonds, because it is by purchasing ultra-safe government bonds that annuity companies are able to offset their annuity liabilities.

The lower the yield on government bonds, the lower that annuity-buyers will be able to get.

The recent bout of volatility in markets has included big falls for government bond yields. These are a result of more investors wanting to buy bonds over more risky assets. Because demand is high, investors are willing to accept a lower yield.

So extreme has pricing become that a range of bonds issued by some nations - including Japan and Germany - now pay a negative yield. That means investors are buying them knowing that they will lose money - it’s the fear of losing more somewhere else that is motivating them.

If you’re trying to buy bonds for a yield to support annuities, this is a big problem. UK government bond - or gilt - yields are not yet in negative territory but they have been falling. The gilts that underpin annuities in the UK currently yield just 0.76%, down from 1.75% a year ago, and there has been a corresponding fall in annuity rates.

In October last year the average annuity rate was 5.16%. This means a £100,000 retirement pot would be able to generate £5,160 of guarantee income. The rate today is just 4.59%, with a comparable income of £4,590. If you want an annuity that increases the income it pays in line with inflation, or comes with a guarantee to pay income for a period after you die, the rate may be even less.

Annuities do remain a key part of many retirement income plans. Guaranteed income is very hard to come by and many people will not be willing or able to let the entirety of their retirement income be exposed to market ups and downs.

Such low rates on annuities, however, are forcing more to consider whether they need to use more flexible drawdown plans to access their retirement savings while keeping them invested. There are a few ways to do this, and you can read about them here, but the main difference between drawdown and an annuity is that drawdown allows you to keep your pot of money and invest it to create an income. Unlike an annuity, income is not guaranteed and depends on the performance of assets like shares and bonds.

It suits some people to use both - annuitising some of their retirement fund to create a guaranteed income that covers their essential costs but leaving some money invested to take advantage of the potentially higher returns from markets.

Whether to buy an annuity or use drawdown instead depends on many factors. The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.pensionwise.gov.uk or over the telephone on 0800 138 3944. Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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