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Feast of the assumptions

This week, I will conclude my series of articles on recent and imminent developments in the pension world. In my last article, I looked at issues relating to the pro- jection of benefits from final-salary schemes and state pensions. Here, I will move on to the projection of money-purchase benefits, paying particular attention to the impact of statutory money-purchase illustrations.

I will start by looking at illustrations for accumula- ted pension funds before expanding the discussion to ongoing contributions.

Statutory money-purchase illustrations dictate the assumptions which must be used to arrive at projections for money-purchase schemes. These include fund growth, future inflation and eventual factors affecting annuity rates when the fund is likely to be vested, with the pro- jected fund expressed as an annualised income.

It is worth reminding ourselves of the primary reason why it has been deemed necessary to insist on the format of the SMPI. Over the past 30 years or so, alongside the expansion of the money-purchase pension market, much marketing effort has been directed towards recommending products based around projected funds.

In the early years, product providers and distributors were able to use almost any investment growth rate considered even mildly justifiable. The projected fund almost invariably gave no indication of its likely true value if inflation were taken into account and many buyers were – probably inadvertently, in most cases – led to believe they were likely to be able to provide themselves with substantial pension funds for relatively little commitment to regular contributions.

Where these projections included a conversion of the projected fund to an annual income, the mathematical assumptions used in that conversion were invariably based on annuity rates at that time. As is now widely appreciated, such bases for annuity assumptions have proved wildly false, as falling interest rates and increasing life expectancy have contrived to force annuity factors much lower than projected.

The combined impact of these factors has led to money- purchase members accumulating far lower funds than anticipated as growth rates have in most cases nowhere near lived up to the expectations expressed in the original illustrations, even ignoring the effect of inflation.

Clients’ sadness at this underperformance has often been heightened to the point of despair as they realise that the disappointing size of the fund will buy a much lower level of annual income than had been initially projected.

Hence, the introduction of SMPI in 2003. In the words of the Department of Work and Pensions press release at the time: “The money-purchase pension illustration will give people an idea of what their future pension might be expressed in today’s prices. It will give them a realistic idea of the spending power of their pension and help them plan their savings more effectively.”

Mostly, I would agree with this sentiment but I feel strongly that advisers and their clients have not been properly encouraged to think about the effect on the future pension if the assumptions dictated within SMPI do not materialise.

As an important example, SMPI introduced a requirement for projections to be based on a single pre-retirement rate of return of 7 per cent, in contrast to the three projections required by the FSA at 5, 7 and 9 per cent. Nothing too outrageous about this, you might think, but surely the likely future rate of investment growth will depend to a very large extent on the fund to which the client’s money is directed?

Thus, it could be argued that while a 7 per cent pro- jection might be considered realistic for equity funds over the longer term, 5 per cent could be more realistic for fixed-interest funds. For cash or deposit-based funds, even 5 per cent looks ambitious.

I accept that the SMPI regulations make mention of the desirability of using an assumed growth rate lower than 7 per cent for non-equity-based funds but what would be the most appropriate assumption for a managed fund? Do we differentiate between different providers’ managed funds depending on the proportion of each fund allocated to each major asset class?

Certainly, we should, but this consideration is not a feature of SMPI. Within the fixed-interest market, even a slight understanding of the market would suggest that different assumptions should be used for high-yield and blue-chip corporate bond funds which, in turn, would be expected to produce different rates of growth from Government bonds.

Many other examples spring to mind but, for the sake of brevity, I would suggest that the use of a single assumed growth rate in any illustration is highly dangerous, not least because the client could amend his asset allocation as the years pass, making any single initial assumption obsolete.

The use of three assumptions – even if not necessarily the current three – allows the adviser to direct the client’s attention more towards the assumption most appropriate to the client’s asset allocation at that time. I suggest that we advisers should note the shortcomings of the SMPI format and adapt the format of our advice accordingly.

We must also be aware of the assumption of inflation at 2.5 per cent. This is fair enough in the current economic environment, so I suppose the only real issue here is an explanation to the client as to why his recent annual illustrations are so much lower than those he received before the introduction of SMPI a couple of years ago.

More important, though, is the assumption that the fund will be used to buy an annuity which increases in line with RPI – therefore providing an income which is typically about 30 per cent lower than a level pension – and that the annuity assu- mes a 50 per cent spouse’s pension – typically, a further 20 per cent reduction in annuity income – unless agreed to the contrary.

Of course, at retirement, many clients will opt for a level pension for maximum initial income and will not want a spouse’s pension. Thus, SMPI could lead some scheme members to believe that their eventual pension could be around 50 per cent lower than that provided by their likely choice of annuity.

Finally, moving on to the life expectancy assumptions within SMPI, these are based on mortality tables almost 15 years old and I am informed by a couple of life offices that their internal mortality experience indicates continuing improvement in life expectancy. If so, we can perhaps expect to see lower annuity rates than those assumed within SMPI, indicating a need for greater investment provision for retirement income.

In summary, SMPI is leading to a more useful set of assumptions but we need to be able to advise sensibly on the possibility of any combination of those assumptions not materialising.

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