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Keyhole to the future

In this series of articles, I have been looking at the considerations which should be taken into account in determining whether an individual with preserved defined-benefit pension benefits should effect a transfer to some alternative pension arrangement – such as a personal pension, pension buyout bond or a new employer&#39s pension scheme.

As a structure for these considerations, I am working through the stages in the calculation of transfer values, which run as follows:

Identify and quantify the value of the individual&#39s preserved pension benefits, including death benefits.

Revalue those preserved benefits to the scheme&#39s normal retirement age.

Calculate the lump sum required at that time to buy those revalued benefits.

Discount that lump sum back to the present value; and (in some cases)

Make an adjustment for that discounting, taking account of current investment market conditions.

In last week&#39s article we concluded stage two. I invited readers to consider the variable factors which must be determined in stage three and the effect those variables might have not only on the calculation of this stage but, more particularly, how those might affect the decision on whether or not the client should effect a transfer. Stage three is the subject of this week&#39s article.

In determining the anticipated lump sum likely to be required, at the individual&#39s normal retirement age, to be able to buy the revalued pension benefits it is necessary to determine the likely annuity rate at that time.

Although most final-salary schemes do not buy an annuity to provide for their pensioners&#39 benefits (preferring to pay the ongoing liability directly out of scheme funds), the notional cost of providing those benefits must be used.

In some cases, this notional cost will be cheaper than the annuity purchase price due to the absence of – or at least a significant reduction in – the allowance for charges where the benefits are provided by the scheme.

This in turn cuts out the insurance company&#39s (annuity provider&#39s) additional costs including, for example, commission to an intermediary.

Charges aside, the main assumptions which must be used relate primarily to interest rates, life expectancy, the escalation rate the scheme will or may apply to the pension in payment and the cost of providing survivors&#39 death benefits from that time.

The issue relating to life expectancy has only fairly recently come more to the attention of schemes and pension advisers in relation to its potential importance.

First, let us look at the level of future interest rates.

Actuaries do not use short-term interest rates in this calculation, as it is the likely interest rate at the individual&#39s normal retirement age – often decades into the future – which will determine the cost (or notional cost) of providing the pension benefits.

Unless the escalation to the pension benefits is provided in the form of an inflation-linked pension, the cost of buying the annuity will be determined not by interest rates but by the long-term assumption of future inflation rate. The actuary will turn to the fixed-interest Government bond market for guidance.

Turning to and developing our example from last week of John&#39s preserved pension, he had 20 years to go to his normal retirement age, at which time his expected revalued pension benefits are anticipated to be around £21,000 a year.

If the pension benefits are to be provided on a level basis or at a fixed rate of escalation in payment, then a crucial assumption for the actuary to make will be the anticipated level of interest rates 20 years from now.

He will therefore look primarily at the redemption yield on a fixed-interest gilt with 20 years to redemption as this indicates the level of interest rates the stockmarket expects over the next 20 years.

At time of writing, a few days before you read this, this redemption yield was a little under 5 per cent. To get the effect of these assumptions into perspective, this would indicate, if the pension is to be payable on a level basis, a lump-sum requirement at that time (to buy the £21,000 a year pension) of around £400,000 (at age 60).

If the actuary&#39s assumption in this respect proves wrong – highly likely, if the history of accuracy in these assumptions is any guide – then the lump-sum requirement could be wildly different from his first “guess”. By way of quick illustration, if the interest rate at the normal retirement age is 10 per cent, the lump sum required to buy John&#39s benefits will be £190,000, not £400,000. This would significantly reduce the notional (or annuity) cost to the scheme of providing the benefits.

Conversely, if the prevailing interest rate at that time is only 3 per cent, then the cost of buying the annuity would be around £500,000. So what is the point of all this for pension transfer assessments?

In making the transfer assessment, we will be trying to identify the rate of growth required from a private pension alternative to match the benefits provided by the existing scheme. If as part of this analysis, we assume the future annuity interest rate of 5 per cent, our assessment will be based on the need to provide a fund of £400,000.

In the past, many pension transfer advisers have considered that the only significant risk to the client in a transfer is the risk of the private pension alternative not providing a fund of £400,000.

However, it should be obvious from the above that a further significant risk of a transfer is the risk that interest rates will, when the annuity is purchased, be lower than those assumed on the transfer analysis program. This risk must be brought to the client&#39s attention if a transfer is to be considered.

Of course, let us also not forget (or forget to bring to the client&#39s attention) the chance that interest rates will be higher than our initial assumption, providing an additional “gain” to the transfer client from the lower cost of buying an annuity – which may be restated as the higher annuity payable from a certain assumed level of future fund.

So, the first of our four considerations at this third stage in the calculation of transfer values is the future assumed level of interest rates. The effect on the transfer recommendation (and especially the risk and reward paragraphs in the reasons-why letter) should be fully understood and acted upon by advisers.

At least equally important, though, is our second major issue at this stage – the impact on life expectancy on transfer value and transfer decision.

It is not a widely known fact among pension advisers that mortality tables over each of the last three decades have progressively shown male life expectancy (for illustration purposes, looking at a 60-year-old male) increasing by three years (that is, a three-year improvement each decade).

If this improvement continues in the future, what will be the impact on pension transfer recommendations? We will see next week.

Keith Popplewell is managing director of Professional Briefing

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