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Into the unknown on interest rate assumptions

I read with interest, as I usually do, the article by Keith Popplewell in last week’s issue of MM.

I concur with the overall message but I would take issue with some of the comments he draws.

I suspect that we would both question the assumptions of a central SMPI growth rate of 7 per cent in conjunction with an assumed rate of inflation of 2.5 per cent but the FSA no longer makes any recommendation as to the assumed rate of inflation at either the upper or lower points. In itself, this is not such a bad thing as the assumed values at the central point can be questioned anyway.

It is the leeway to make ones own assumptions for inflation at these points that gives rise to the problem that he correctly identifies.

However, it is the implication that that real rates of return can be higher with low inflation and lower with high inflation that I find issue with. In particular, the throw-away remark that actuarial logic behind higher average inflation rates over a long period of time being linked with higher equity fund rates is barely supported by historical experience.

If one assumes for simplicity that real rate of return on investments is roughly level irrespective of fund growth, then, using Keith’s figures, the adjusted fund in today’s terms is roughly the same and if one applies current recommended assumptions to calculate the annuity rate the value of the pension in today’s terms, which the client is interested in comes out.

It is then only a case of showing the effect of varying benefits selected with the annuity on the final value (for example, annual increases and/or a reversion for the partner).

Keith is correct when he says the annuity rate is dependent on a single value in the interest rate at the time that the annuity is taken and he rightly avoids bringing mortality into the mix as well. It is explaining the effect of the unknown value of interest rates at retirement which puts the fly in the ointment and makes the job of advice so difficult.

By rights, different assumptions as to underlying assumed interest rates should be made at the higher and lower ends of the spectrum but this complicates the matter even more. Let alone changes in mortality over time, already there are schools of thought that the improvements in mortality have plateaued out and that in 20 years time, life expectancy may have declined instead of increased.

All attempts at trying to put the information to the client as clearly as possible are clouded by excess information from the provider, with no explanation or justification of any of the assumptions made.

By keeping real rate of return level and using current guidelines on mortality, one can at least show the possible value of a pension in today’s terms. Surely the important point is that irrespective of interest rate assumptions what the value of the clients pension if they retired today would be.

Keith Charsley
Actuarial and Financial Consultant
Sesame Desktop Services
Oxford

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