Guest Spot: To switch or not to switch that is the question

  • Author : Adrian Boulding
  • Date : 18 Jun 2020

In this Guest Spot Adrian Boulding, Chief Innovation Officer of technology provider Spire Platform Solutions considers the case for “switching” in retirement cases.

Buy low – sell high

This is the objective of all speculators. But when it comes to pension plans, the buying takes place very gradually over a 40 year working life and the selling takes place almost equally slowly over a thirty year retirement.

Switching, on the other hand, is where the big decisions will lie in retirement planning. And switching is an altogether more complicated matter as it involves a decision to sell one investment and to buy a different investment both at the same time. Large sums of money may be involved, perhaps driven by client events – such as arriving at retirement date – or perhaps driven by market events – such as change in policy by the Bank of England.

This article invites advisers to consider whether one of those market moments has arisen as a result of the response to and fall out from Covid-19. It concentrates on clients in the early years of income drawdown, who probably have the largest amount of money invested they have ever had or will have going forward. So it could be a very large and significant switch.

I want to look mainly at the case for switching out of corporate bonds and into annuities. I’ll come back later in the piece and look at the argument for switching out of equities too, but I’m aware that in the main advisers had to spend March and April restraining clients whose natural response to free falling equity markets was to cry “get me out of here”, as selling at the bottom would have been a case of acting in haste and repenting at leisure.

Bonds have not been hit anything like as badly as equities by Covid-19. At the low point in March, while UK equities were 30% down since the start of the year, UK bonds, as measured by iBoxx all maturities index, were only 10% down, a loss they have since fully recovered. In part this is because the Bank of England, on 19th March, cut its base rate to 0.1%pa, the second cut they made in nine days of blind panic. For structural reasons, 0.1% is as low as the Bank can go, so we’ve hit rock bottom.

Outside of gilt edged stock, most corporate bonds are of fairly short duration, so their price is heavily influenced by a combination of today’s bank base rate and a market expectation of where that base rate will be over the next few years. And if base rate can’t go much further down, then bond values can’t go much further up.

But the case for switching out of corporate bonds is much stronger than an opinion on future interest rates. I’m talking about the unintended consequences of the movement that’s become known as “Build Back Better”. In all walks of life, I’m seeing a growing determination that as we return to normal from the Covid-19 lockdown, it will be not to the old normal, but to a new, better normal. More flexible working, shorter working hours, more exercise, wider pavements and cycle lanes, fewer emissions, just bring it on, the new normal will usher in changes as radical as society saw after the Great War of 1914-18

While some companies will prosper, others will fail when they either can’t or don’t adapt their business model to new normal conditions. For bondholders this is going to be an uncomfortably asymmetric experience. If the company they have invested does well, the bondholder continues to receive the promised low rate of coupon. But if the company flounders, then the bonds default and some or all of the investor’s capital is lost.

Wouldn’t it be nice if you could switch some of your client’s bonds into another investment that offered the low risk and predictability traditionally associated with bonds, but without that default risk? Amazingly there is an alternative to bonds that has these characteristics!

The humble annuity offers just this combination of certain returns and no default risk. An annuity is very bond-like, in that it promises a series of known payments on fixed dates. In fact it’s so bond-like that the insurance companies that issue annuities buy corporate bonds to back their annuities.

The great news about this switch – sell bonds, buy annuity – is that the default risk is passed from client to insurer. All that moaning about Solvency II that insurers made was because they have to hold levels of reserves that will keep them afloat even when their bonds default. And there’s a backstop beyond that too. In the highly unlikely event of an insurance company collapsing, the Financial Services Compensation Scheme will pay all the future annuity payments in full with no upper limit.

It’s looking through this long term lens that annuities outscore bonds. Typically the addition of an annuity to a client’s portfolio improves the stability of long term income. The flip side of that of course is that the portfolio value on early death available to your client’s heirs will be lower when bonds are switched to annuities.

Returning to equities, is it just too heretical to think of switching from equities to annuity? Factors that an adviser might like to consider in reviewing a client’s equity proportion include that equities have recovered somewhat from their direst lows back in March. Also there is an unseen danger – many firms have taken on huge additional debts to see them through the economic inactivity of lockdown and furlough, and there is pressure in the wings to have some of that debt turned into equity, a move that may reduce the stake of existing equity owners.

If you’ve come this far with me, then I’d ask two favours of you before your next client meeting. Go and get an annuity quote so you can see where rates are today, and think about where you would hold that annuity, either as a traditional stand-alone annuity or nestled inside your client’s flexi-access drawdown sipp.

The statements and opinions expressed in the Guest Spot are those of the author and do not necessarily reflect those of Novia Financial plc or any of its employees. The company does not take any responsibility for the views of the author. Any links, web pages and documentation within the Guest Spot are provided by pages maintained by independent third parties and Novia accepts no responsibility for the availability, content or use of the information contained within them.

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