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Growing concerns

I would like to turn my attention this week to the importance of applying some basic mathematics to the subject of pension planning, as prompted by some recent questions from a client. Having been presented with a statutory money-purchase illustration from his pension provider, he asked my guidance on the effect of any of the assumptions used in the report proving incorrect.

The client queried every major assumption used in the illustration and, in particular, challenged the relationship between the percentages used to predict future growth. For the ease of explanation in this article, I will simplify the conversation and the mathematics involved.

First, the client queried the lower assumed growth rate on his transferred fund of 50,000 over the 20-year term to his expected vesting age of 65. At 5 per cent, this fund could be expected to grow to 130,000 in absolute terms, that is, before allowing for the effects of inflation.

After allowing for inflation at the SMPI assumption deemed appropriate to this lower growth rate of just 0.5 per cent, the illustrated real value of this fund was a little under 117,000.

The client suggested that this projection seemed very encouraging but expressed some doubt as to the validity of the apparent assumption that a low growth rate was likely to occur when inflation was low.

After all, he suggested that if his fund were to be invested in Government fixed-rate bonds, it was quite conceivable, based on current market expectations, that his fund would only grow by around 4.5 per cent a year over a period of time when the money markets appear to expect inflation to average 2.5 per cent a year.

This is where the maths really starts. At 4.5 per cent a year, his fund would grow in absolute terms to around 120,000. However, adjusted for the effects of inflation at 2.5 per cent a year, the buying power of this fund would be only 79,000 – about 40 per cent lower than the SMPI figure.

“So,” my client asked, “which combination of assumptions should be used in planning the extent of the need for further retirement income provision?”

“Good question,” was my obvious reply, especially when we started to consider the mid-range and higher-range assumptions which seemed more appropriate in the light of the portfolio I was recommending.

Is it beyond the bounds of all possibility that the higher rate of growth of 9 per cent might be achieved even in the absence of an inflation rate lower than the 4.5 per cent assumption? Without wishing to unduly over-complicate the mathematics behind these questions, I would also like to pre-empt the mention later in this article of the eventual annuity rate at the vesting date. For now, though, I will restrict my discussion simply to the combination of fund growth and inflation rate, as noted in the table (above).

So what is the financial planning purpose in writing an article about all this mumbo-jumbo? Depending on the assumptions used in the calculations summarised in the table, the true value of the client’s fund could be anywhere between 54,000 (low assumed growth with high inflation) and 250,000 (high assumed growth and very low inflation).

Now, I am by no means trying to rebel against the use of the SMPI, nor am I entirely calling into question the logic behind the relationships between different sets of assumptions. I am, in this article, trying to bring to the attention of financial advisers and their clients the extent of the different values depending on the actual outcome of fund growth and inflation and, therefore, the need for the client and adviser to review the situation at regular intervals. At least once a year, as is relatively common practice, is necessary.

An eventual fund of 54,000 might lead to an annuity of only, say, 4,300 a year, depending on the annuity options selected, while a fund of 250,000 would lead to an annual income of 20,000 a year, using the same combination of annuity options . That would make a great deal of difference to the vast majority of clients, I would suggest. Even ignoring the different growth rates, simply applying different assumed inflation rates can make a massive difference to a client’s financial life, as shown in the table.

That brings us on to the assumed eventual annuity rate. I feel this is the most likely assumption to be proved wrong. Quite apart from the mortality trends, a single-life annuity at an assumed underlying interest rate of 2 per cent (close to the annuity rate linked to the lower growth rate of 5 per cent and lower inflation rate of 0.5 per cent) would yield around 65 per 1,000 of purchase money for a 65-year-old male. An underlying interest rate of 4 per cent would yield around 85 per 1,000 while a rate of 6 per cent would yield around 92 per 1,000.

If we were to factor these differences into the calculations in the table (which I have not done because I fear the mathematics would then certainly and confuse my main message for this article), it is easy to see how the potential differences in eventual income to the client would be even more exaggerated.

I will, though, encourage you to spend just a little more time questioning why 5 per cent fund growth might be more or less likely to lead to a fund which enjoys or suffers an eventual underlying annuity rate of either 2, 4 or 6 per cent.

I understand the actuarial logic (which is barely supported by historical experience) behind higher average inflation rates over a long period of time being linked with higher equity fund growth rates but the underlying annuity rate does not depend on aver- ages over a period of time, it relies on interest rates at a fixed time in the future.

Moreover, I will return momentarily to one of my old hobby-horses and question the logic behind the same fund growth rates being illustrated almost regardless of asset and sector allocation within the recommended portfolio.

Having said all this, it must be accepted that the SMPI represents a much fairer method of illustration for the client than its predecessor. I would struggle to suggest anything much better but I strongly feel that the financial services community could benefit itself and our clients by truly understanding the extent of possible variances in the assumptions and the financial planning action which should be put in place at clients’ annual reviews, depending on the variances of reality compared with the initial assumptions.

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