When a company wants to raise money, in addition to borrowing from traditional sources, it has the option to sell shares in the open market. This can happen when a private company turns itself into a public company by launching shares on the stock exchange or it can also occur where an existing public company issues more shares in order to raise a new tranche of funds. All of these types of transactions take place in what is known as the primary market.
Unless investors become involved in the initial offerings all other buying and selling of shares are transacted in the secondary market. The same principle holds for government bonds, corporate bonds and a host of other financial products.
Consider a pension fund or an insurance company that had invested in a 30-year government bond 10 years ago when the bond was initially launched – so the transaction was carried out in the primary market. Now the insurance company needs some of the money back and cannot wait 20 years until the bond matures. So it offers a deal to other investors in the secondary market. Given that a 30-year bond issued 10 years ago carries a very good interest rate (coupon) – compared with bonds issued today- it should prove attractive to an investor with a 20-year view.
The same process holds true for any financial commodity and the existence of a flourishing secondary market provides good two-way pricing for buyers and sellers. In jargon-speak – liquidity- or the chance for an investor to exit a deal before the maturity date.
This all sounds hunky-dory until it impacts on consumers. Pension legislation has been given a complete overhaul in recent times and we have written before of how Ireland has led the way in much of this innovation. Ireland was the first European country to allow retirees the option to keep their pension fund intact and not purchase a compulsory annuity contract (salary for life).
This provided real choice at retirement but the choice was not an easy one. A rule of thumb does not apply to individual circumstances where consumers have a personal attachment to pension funds that they have assiduously accumulated over many years. While other consumers see the logic in handing over the fund proceeds in exchange for a pension for the rest of their days.
Traditionally, the purchase of an annuity contract was irreversible. The retiree bought the salary for life with the pension pot and lived with the decision….not any longer! The UK has just introduced pension rules that will allow retirees who have purchased an annuity to “trade” the contract in the secondary market. This effectively allows the retiree to recoup the pension pot that was lost when the annuity was purchased.
The pros and cons of annuities are debated with much gusto by actuaries and the argument is really undecided. Allowing retirees to trade their life income on secondary markets is irresponsible unless it is accompanied by rigorous controls.