Back in November 2012, as advisers peered over the RDR precipice, the FSA set out changes to the way insurers calculate the future value of people’s pension pots.
The changes to pension illustrations, which came into force on 6 April, are very likely to mean that projections for future fund values look significantly worse than they previously did.
Under the new requirements, investment projection rates have been cut from 5, 7 and 9 per cent to 2, 5 and 8. Illustrations also have to factor in inflation at 2.5 per cent.
All this means projections at the lower growth rate can leave clients holding a pension statement which suggests negative returns.
The new projections are likely to lead to some difficult conversations as clients see the future value of their potential assets reduce.
Isas versus pensions
While Isas are affected by the changes to projection rates, they do not have to account for 2.5 per cent inflation, meaning clients may start seeing pensions as the less attractive investment vehicle.
Software provider Dunstan Thomas supplies illustrations to a number of providers, Sipp operators and platforms. Managing director Natanje Holt says: “As the changes are not applicable to Isas immediately pension are put at a disadvantage.”
Scottish Widows head of pensions market development Ian Naismith agrees. He says: “An illustration on an Isa does not reflect the impact of inflation so it makes it look like an Isa provides a better return, which is not really the case.”
Advice firm Derbyshire Booth managing director Greg Heath has already had some clients baulk at their new illustrations. As a result clients have been deterred from making further pension contributions and signalled they want to move out of their pension into another investment.
He says while the changes to illustrations were explained to clients ahead of time, the inflation factor has really driven it home.
He adds: “We have communicated these changes to clients to allow them to make informed decisions but the changes have resulted in some negative reactions when they actually seethe new illustrations.”
In its policy statement on the changes, published in March 2013, the regulator noted the risk of consumers pensions to be “poor value for money, which could potentially result in lower sales of pensions contracts.”
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But ultimately the FSA felt the benefits of setting out projections in real terms outweighed the drawbacks.
The regulator initially considered forcing providers to write inflation-adjusted projections for drawdown illustrations and to allow for inflation within annuity quotes. It later decided against both options.
The FCA says it will monitor whether providers are adhering to the Association of British Insurers’ code of conduct on retirement choices. The voluntary code says providers will make consumers aware at-retirement of escalating annuities options and the impact of inflation.
The regulator also judged that the cost of implementing inflation-adjusted drawdown illustrations would be too high. In its final rules it states firms can provide inflation-adjusted reports voluntarily.
It is hoped the changes to projections will prompt frank discussions between advisers and clients.
Heath says: “Changes like this are always unpleasant because people look at the illustration and think they are going to be worse off, when in fact all that has changed is how the growth rate is calculated.”
Naismith believes that overall the new system represents a better way of working than the old system.
He says: “Some clients will look at an illustration, see that they are expected to have £9,000 when they put in £10,000 and will start asking what is going on. Handled the right way, that is a good conversation to be having.
“Advisers need to be having those kind of conversations with clients, explaining it is not just about the low return, but the range, and to get the client thinking about potential outcomes. The adviser and the client need to discuss the fact that the client could make a loss. The FCA illustrations almost force that conversation, which I think is a good thing.”
Have changes been overlooked?
Providers suggest that while some advisers have communicated the changes to clients well in advance, others have been less prepared.
Standard Life head of adviser business development Duncan Muir says: “From our feedback from advisers there appears to be a mixed level of awareness of the changes. After highlighting how the new projections were being calculated – particularly given the lowest growth rate would be in negative territory – advisers did say it would lead to some interesting and challenging discussions with clients. But many also questioned how relevant the illustrations were in the first place.”
The FSA initially estimated the cost to providers of implementing the changes to projection rates would be around £25m. It then later revised this up to £29m to include the impact on Sipp operators.
Pensions are at the moment out of scope of the packaged retail and insurance based investment products regulation, though this will be reviewed in four years time. This could see the new projection rates in place in the UK replaced by a new European disclosure regime further down the line.
Naismith says there is still work to be done to improve the UK method of calculating projected fund values. He points out the need to have the growth rates set 3 per cent apart could prove problematic depending on a client’s asset allocation.
Naismith says: “If you have got an equity fund having a three per cent difference between the different growth rates is perfectly sensible. But if you have got a cash fund it is going to move in a much narrower band so perhaps a two per cent band would be more realistic. Some more flexibility to move that would be quite good.”
But he adds although the FCA approach may not be realistic in all circumstances, it at least gives clients numbers they can engage with.
What future for illustrations?
Muir suggests if clients and advisers start viewing projections as meaningless numbers, the documents could be dropped altogether.
He says: “We would like the regulator to continue to review the requirements for illustrations. Should illustrations become a piece of documentation that is held on file and does not play an active role in the financial planning process, there is a question to be asked about their future.”
The danger is if confronted with this attitude, the FCA may force advisers’ hands further and compel them to have a conversation with clients around the illustration.
Taxbriefs editorial director Danby Bloch says the changes cannot be ignored and could have a profound impact on charges.
He says: “Some clients will not look at illustrations but others will. For those that do, there will have to be a discussion. People will start looking even more for funds that are inexpensive and more may start to look seriously at exchange traded funds.
“Longer-term there is also the wrap platform charge which could come under more pressure.”
He also believes the adviser charge could also be set to come under pressure.
Bloch adds: “Clients are going to start asking how a 1 per cent charge is justified. In any business, you cannot be complacent about what you charge and it will become even more important for advisers to demonstrate value.”
Key points of the FCA’s projection rules
- Projection growth rates cut from 5, 7 and 9 per cent to 2, 5 and 8 per cent with effect from 6 April
- Projections will have to show how returns are impacted by a 2.5 per cent rate of inflation. Providers will have to include a statement about the effect of inflation on other savings and investment products
- Drawdown providers will not be required to provide inflation-adjusted projections. The regualtor said when it published its final rules that it may review this in future. Annuity quotes also do not have to factor in inflation.
- Some consumers may find illustrations in real terms too complex to understand, particularly if they do not have an adviser. This may often be the case with auto-enrolment
- There is a potential for pension sales to fall if they appear to be worse value than other products
- The same basis for projections should be extended to other packaged products, such as Isas
ADVISER VIEW: Tom Kean
These changes are tinkering for no good reason. The only thing it achieves is to add confusion and potentially put people off saving. People will save as much as they feel able and a piece of theoretical maths on a piece of paper is not going to change that.
Tom Kean is director at Thameside Financial Planning
ADVISER VIEW: Tim Page
We tend to use long-term cashflow modelling in discussion with
clients about investments and that uses similar assumptions those in the FCA illustrations. We give them that analysis before they get the illustration.
One purpose of illustrations is they are supposed to help with comparing pension products. But I suspect some consumers are more likely to use them to compare with alternative investments like buy-to-let property, which is not comparing apples with apples.
Tim Page is chartered financial planner at Page Russell
EXPERT VIEW: Andrew Tully
From 6 April the FCA reduced the projection rates for pension illustrations from 5, 7 and 9 per cent to 2, 5 and 8 per cent. Advisers will need to help people understand these illustrations, and why projected benefits may have reduced from previous statements.
Some providers chose to use fund-specific growth rates instead, due to concerns the standard rates could overstate the potential growth of a particular fund. So the changes may make little difference to many cautious and balanced fund projections.
For pension statements the illustrations must also take into account the effect of inflation which means benefits at the lower projection rate may well be negative, and that will need explaining to clients.
Similar changes have been made to projections for non tax-exempt products (for example endowments and onshore bonds) with the current 4, 6 and 8 per cent growth rates replaced by 1.5, 4.5 and 7.5 per cent.
While these changes have just been introduced, the recent Budget announcements – allowing people much greater flexibility over how they take their pension benefits – mean a fundamental review of all retirement projections is needed. One possibility is to demonstrate at what age funds will run out, given certain levels of withdrawals and investment return.
Andrew Tully is pensions technical director at MGM Advantage