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Target practice

This week, I would like to move away from purely technical issues and start to consider an area of financial planning practice which I have long considered to be badly overlooked or, at the very least, underused or misunderstood – target benefit planning, especially for retirement income.

Much has been said and written about target benefit planning and it has been included increasingly in advanced financial planning books but not, I fear, to the extent that it merits. In these next few articles, I will discuss the principles and strategies which can pay huge dividends for advisers and their clients.

Let me start by defining what I mean by target benefit planning. This aims to ascertain the level of income in real terms that a client requires from a given date in the future – in this respect, from his or her retirement date. From this figure is then deducted the level of income he or she is due to receive from existing sources to arrive at the net shortfall we should be aiming to produce from one or more new arrangements.

This shortfall should then be converted into a capital amount to permit the calculation of a required level of initial and/or ongoing investment to produce that projected lump sum.

If all this sounds just a little too simplistic for this column, I can say with relative certainty that these next few art-icles are likely to raise at least a few eyebrows, not only in the depth to which target benefit advice should be given but also its usefulness.

In particular, I will be looking at the variables which have to be assumed in the target benefit advice process and the extent to which these variables should be revisited on a frequent basis after the initial advice is given in order to revise the recommendation.

The main assumptions which must be made at each stage of the advice process are shown in the table above.

In looking closer at each stage, I will start at the point when we will usually have to make assumptions as to the anticipated level of price or wage inflation between the date of the planning exercise and the date at which income is required. The need for this assumption is based on the near certainty that the client is likely to express his future retirement income need not at a level payable at that future date but in today&#39s terms.

Thus, for example, a 40-year-old client might speculate that his required retirement income level from age 60 will be, say, £20,000 a year in today&#39s terms. This figure might simply have been plucked out of the air or might have been teased out of him by more detailed questioning about his future income needs relative to his current expenditure. So, for example, it might perhaps exclude mortgage payments which might not continue into retirement.

Other clients might suggest their future income needs as, for example, 50 per cent of their current earnings.

In any event, the key aspect of this stage of the advice process, in terms of the assumptions to be used, is the future level of price or earnings inflation. I have, in fact, in previous articles mentioned the only widely acceptable method for financial advisers – a quick calculation from the prevailing returns on fixed-interest and index-linked Government bonds, as follows:

•Current redemption yield on a 20-year fixed-interest Government bond – 5 per cent.

•Current redemption yield on a 20-year index-linked Government bond – 2.75 per cent. Note that the published redemption yield of 2.75 per cent means, in fact, 2.75 per cent plus protection against price inflation, that is, 2.75 per cent plus RPI.

Now, these redemption yields do not happen by accident. They are a product of the prevailing market price of these bonds which, in turn, is a product of their respective and comparative levels of supply and demand. If the market (in this case, institutional investors) believes one of these gilts represents poor value for money, they will stop buying it, the price will fall and the redemption yield will increase.

Therefore, at any given point in time, it may be assumed that the two yields are in what may be called equilibrium. That is, the market believes they are likely to offer exactly the same potential value over the next 20 years.

For these two bonds to offer the same value, the simple equation arises that the market believes that 5 per cent a year will be equal to 2.75 per cent plus RPI, which implies that the market believes price inflation over the next 20 years will average 2.25 per cent a year.

So we can now return to our target benefit planning exercise, noting that I have deliberately selected gilts with a 20-year redemption period, matching the period of our retirement planning exercise.

In our example, we have the task of ensuring that the client enjoys a level of income in retirement, starting in 20 years time, of £20,000 a year in today&#39s terms. If we take this to mean £20,000 after allowing for the effect of price inflation, then we must increase this target by a factor of 1.56 (that is, 1 x 2.25 per cent over 20 years) leading to an abso-lute target income of £31,210 a year.

If, however, the client specifies that the target income should be relative to his expected wage increases rather than expected price increases, we should use a different factor. It is an historical fact that wage rises have tended to outstrip price rises in most years, typically by around 1.5 per cent a year over the longer period. So, where a client wishes his retirement income to relate to his final earnings just prior to retirement, we should increase the target income by an ann-ual percentage of somewhere around 3.75 per cent.

This figure is derived from the expected future rate of price increases (derived from the gilt market, as noted above) plus the expectation that wage rises will continue to outstrip price rises. In our example, this would indicate a target retirement income of 2.09 x £20,000 or £41,800 a year.

In future weeks, we will ponder the likelihood that the rate of price or wage increase we originally decide upon will actually materialise exactly over the next 20 years. The answer to this is a tremendous pointer for the need for regularly revised target benefit exercises for all clients. We will discuss this as part of my next article.

Keith Popplewell is managing director of Professional Briefing

Assumptions to be made in target benefit planning

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