Annuity rates have leapt 50% since the start of the year with a £100,000 pension pot paying a guaranteed income of £6,873 a year, up from the £4,521 just nine months ago.

While this is great news for anyone looking to buy an annuity, it’s “cold comfort” to those who have no intention of buying one, according to Laith Khalaf, head of investment analysis at AJ Bell.

This is because since the dawn of pension freedoms in 2015, just one in ten pension savers buys an annuity. The remainder keep their pension fund invested or simply draw it all out in cash.

But because of older pension savers’ exposure to “obsolete” annuity hedging funds, they have found themselves in a bond nightmare, Khalaf said.

As pension savers approach retirement, their investments are shifted towards a de-risking strategy, with greater allocation of funds in annuity hedging (lifestyle funds) and cash.

However, figures from AJ Bell revealed the average annuity hedging fund has fallen 38% so far in 2022 and by 5% since the mini Budget last month.

“Many investors will therefore now simply be sitting on much smaller pensions than they were at the beginning of the year, as a result of the bond market sell-off,” Khalaf said.

Annuity hedging funds

Annuity hedging funds protect against annuity rate falls. These strategies were common among workplace pension defaults of the nineties and noughties, and in individual stakeholder pension plans too.

They are designed to reduce retirement income volatility for pension savers. This is because annuity-hedging funds invest in long-dated bonds, where yield plays a major part in determining annuity rates. If annuity rates go down, their annuity-hedging fund goes up.

Khalaf added that savers in these schemes “were never encouraged to engage with their pension investments, on the basis it’s all taken care of for them”.

He said: “No investor is going to complain if their pension fund is going up as they approach retirement, whether they’re buying an annuity or not. That’s not the case if their pension fund has plunged just as they are about to draw on it. That’s the situation we’re now facing, as monetary policy has rapidly changed direction and the latest round of fiscal policy has added further fuel to the bond fire,” Khalaf said.

He added “the calamity” of the sharp drop in annuity-hedging funds is two-fold.

“Pension savers are shifted into these funds just as they are about to retire – a process known as lifestyling – so have little or no time to rebuild their pension savings after sustaining losses. What’s more, many of them probably won’t even know the switch to an annuity-hedging fund is happening,” he said.

However, he added that investors in lifestyling strategies would be unlikely to have felt the full force of the 38% drop in annuity hedging funds, as savers are gradually shifted into them, and there is usually a cash element too.

“But those within their last year before retirement could have 60% or more of their pension invested in an annuity hedging fund, so a 38% fall would translate into a hit of around 23% to their overall pension value. Those who are further away from their retirement date will have suffered less, though they are still be invested in a strategy that’s exposed to the bond market, and may not be appropriate for them if they’re not planning on buying an annuity,” Khalaf said.

‘Folly of relying on defaults’

He said the “obsolete” nature of these lifestyling strategies since the pension freedoms has been disguised by the “flattering effect of ultra-loose monetary policy” as low interest rates have driven up bond prices – and the value of annuity hedging funds.

But the recent fall in bond prices prompted by the mini Budget “has added insult to injury”.

Following the Bank of England’s emergency life support, Khalaf said: “It’s possible the worst is now over, and gilt prices have found a new equilibrium.”

He added: “But despite the steep bond price falls we’ve seen this year, inflation and rising interest rates are still a clear and present danger to the bond market. Particularly when combined with the additional supply coming to the market to fund the government’s latest tax cuts and energy price freeze, and the £80bn unwinding of QE planned by the Bank of England over the next year. We certainly shouldn’t expect gilt prices to simply flip back up to where they were a year ago, when the benchmark 10-year gilt yield sat at a breezy 1% (it now stands at around 4%).”

He concluded: “The plight that lifestyled pension schemes find themselves in today really exposes the folly of relying on defaults which put in place an automatic investment strategy many years, or even decades, before that strategy starts to be executed. During this time, there can clearly be changes in capital markets, consumer behaviour or regulation, which can render such strategies obsolete and potentially dangerous.”