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Rates of change

I am now heading towards the conclusion of this series on the methods and assumptions which should be used in formulating an investment recommendation for a client based on targeted levels of benefit.

I have been discussing the way in which expected benefits from different types of pension scheme should be taken into account, dividing this discussion between state and private pensions and between defined-benefit and defined-contribution arrangements.

Of particular significance to money-purchase arrangements will be the introduction next year of the new annual benefit statements, requiring a higher level of forward assumptions than is currently employed by most providers.

Foremost among these assumptions are the anticipated future investment growth rate and anticipated final annuity rate. The first has already been discussed in my recent articles, so it is the second which I will cover here. It is the annuity rate assumption which has been at the centre of much media reporting in recent months and which, almost single-handedly, has led to the requirement for amended money-purchase benefit statements.

Interest rates have fallen dramatically over the last 20 years or so from a peak of over 15 per cent to the current level of around 5 per cent (redemption yield on long-term gilts). This yield is particularly important to annuity rates, which have also fallen over this time period. Money-purchase pension illustrations from 20 years ago used assumed investment growth rates and projected annuity rates deemed appropriate to market conditions at that time. Thus, investment returns of up to 13 per cent a year were commonplace, as were annuity rate assumptions based on future interest rates of 12 per cent or more. This combination of factors led pension policyholders to believe not only that they were likely to amass a fund much higher than now seems likely but also that this fund would be able to purchase a level of pension income at a far higher level – pound for pound – than current interest rates now indicate.

Twenty years on, this client finds that his pension fund has not enjoyed the growth rates suggested in his original illustration and so, for example, his fund stands at only £100,000 in contrast to the £150,000 he had originally anticipated. Moreover, instead of an annuity rate of around £15 per £100 of fund (and therefore an annual income of around £22,500 from a fund of £150,000), he now finds that he can only secure an annuity rate of around £8 per £100 of fund (and therefore an annual income of only £8,000 from a fund of £100,000).

In reality, as it has transpired, this client would have had to make contributions at around three times the level of his actual commitment to secure a required income level of £22,500 a year. But, of course, it is now too late. He has to survive on only one-third of the income he had anticipated. What, then, should have happened, both initially and on an ongoing basis?

It could be argued that the initial assumption of future annuity rates was too high but it should be remembered that, at the time, the assumption seemed perfectly reasonable. Target benefit recommendations do not pretend to achieve a high level of predictive accuracy but they do require these predictions to be reviewed on a regular basis.

So, in our quick example, progressively over the first few years, the adviser would have brought the client&#39s attention to the fact that investment returns were not living up to expectations and so, if the target income level was to be met, the client must increase his contributions. Moreover, the same review would have identified that, as interest rates were falling, so too were annuity rates and, again, even higher levels of contribution would be necessary.

At this stage, the client would have three real options:

•Increase contributions to maintain a realistic chance of achieving the required level of future income.

•Adopt a more aggressive investment strategy in the hope of higher returns -a highly dangerous option.

•Do nothing, in full awareness that future income is highly likely to fall short of expectations and requirements.

Whichever option the client follows, he will do so with his eyes wide open. With the best part of 20 years remaining to his projected retirement age, he has time to make the changes to his strategy necessary to yield his required level of retirement income. This is what target benefit recommendations are all about – making assumptions at the outset and then revisiting those assumptions as part of the regular client review to identify the effect of any deviations from the original projections.

I cannot emphasis strongly enough the importance of this to financial advisers. The new regulations for money-purchase illustrations have been introduced with exactly these issues in mind. The client can identify if remedial action is necessary to achieve his aims, many years before it is too late.

Before ending this review of the importance of pensions in a target benefit plan, it is important to identify the reasons behind why annuity rates have fallen over the last couple of decades. Broadly, life expectancy has increased by around three years per decade for men and two years per decade for women. This has led to a further reduction in annuity rates (on top of that caused by falling interest rates) equivalent for men to a 1 per cent fall in interest rates each decade.

Whether or not such improvements could have been foreseen 20 years ago is irrelevant in target benefit projections. It is perfectly permissible to assume no increase, so long as future developments are factored into the annual review. The new money-purchase illustrations, therefore, include projections using annuity rates which indicate the effect of trends in interest rates and life expectancy. They will make the task of the financial adviser much simpler, so long as the adviser understands the reasons for these new regulations and acts upon them.

Next week, I will summarise the ground we have covered over these last couple of months and suggest ways in which financial advisers can perhaps introduce relatively slight changes in the way they conduct annual client reviews to ensure a significantly higher quality of added value service which – as Ron Sandler stresses throughout his consultation document – is essential in justifying current or increased levels of remuneration.

Keith Popplewell is managing director of Professional Briefing

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