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Unlucky for sum

In my last few articles, I have looked at the crucial messages for

IFAs and their clients which can be derived from mortality tables and

trends in life expectancy, in particular, the adverse effect that

continuing improvement in life expectancy is having on annuity rates

and the cost of funding final-salary schemes, as pension payments are

now being made for anything up to 10 years longer than might have

been assumed a few decades ago.

For money-purchase schemes, members must be made aware that the fund

required to provide a pension income of, say, £20,000 a year is

now much higher than previously projected, partly because of falling

interest rates but also increasing life expectancy.

It is this latter point which brings me on the main subject this week

– the introduction of statutory money-purchase illustrations from

April 2003. For the most part, the perceived need for a change in the

format of projections for pension schemes has arisen because of

disappointment among retiring members of money-purchase schemes at

the level of annuity they have been able to buy with their fund.

A decade or two ago, the first projections to be issued suggested

that a growth rate of up to 13 per cent could be achieved, producing

a huge fund which, when applied to the annuity rates of that time,

produced a similarly huge annual income. What went wrong?

First, 13 per cent growth rate assumptions turned out to be

hopelessly optimistic for most investors, especially those vesting

their pension fund in the last year or so, after a decline in equity

prices and the increasing frequency of market value adjusters on

with-profits funds. Clients hoping for a fund of, say, £200,000

are lucky to have accumulated half that figure in most cases.

Second, little more than a decade ago, long-dated gilts yields were

around the 15 per cent mark. They now languish at less than one-third

of that figure, knocking well over 50 per cent off annuity rates. So

instead of the projected £200,000 fund buying an annuity of

£30,000 a year, the £100,000 fund actually accumulated

would currently be able to buy an annual income of only £7,000,

if interest rates were the only factor in annuity rates.

Third, the additional impact on annuity rates of increasing life

expectancy has had the effect over the last couple of decades of

forcing this £7,000 annuity down to £6,000 a year.

Finally, many of these unfortunate people had not realised that

inflation would take its toll on the true value of the annuity income

emerging from the accumulated fund. The £6,000 annual income to

which they eventually became entitled might be worth less than half

that figure in spending power compared with the date when the

contract was initiated.

In an attempt to prevent similar occurrences impacting on client

expectations, the format of money-purchase pension projections is to

change. But while certain aspects of the changes could be welcomed,

others are much less helpful.

First, although not necessarily in order of importance, projected

funds and annual incomes are to be stated in real terms, that is,

reduced to show an allowance for inflation. The assumed rate of

future inflation is set at 2.5 per cent a year – a figure which leads

to a halving in values over a 30-year period.

Thus, for clients who last looked at their statement a year ago, projections

from April will appear to show a halving in projected values for

someone in their early 30s.

With stockmarkets down by around 20 per cent over the last year, some

of the statements will show a projection some 60 to 70 per cent lower

than a year ago (that is, 50 per cent or more because of inflation

and 20 per cent or more because of fund performance).

Second, rather than the range of assumed growth rates currently in

use (5, 7 and 9 per cent), only a middle rate will be shown (7 per

cent). I feel this is an incredibly unhelpful development which has

been introduced to simplify the statement but will prove to be

dangerously misleading.

The actuarial technical memorandum for the statutory money-purchases

illustration explains that the 7 per cent basis chosen for fund

growth “implicitly assumes that assets are invested in a mix of

investments, predominately equity-based investments”. But what about

the situation where a client is not invested in such a mix? The

memorandum suggests providers should use a lower figure where the

current fund is invested in cash or deposit funds and where there is

no intention to subsequently change to another investment medium.

This is rubbish. Except for clients close to retirement, there will

almost always be an intention to move away from cash at some future

date.

What about funds invested primarily in fixed-interest gilts or high

investment-grade corporate bonds? Neither of these can pretend to be

able to offer any short-term prospect of investment returns higher

than 5 per cent, so a 7 per cent projection is hopelessly ambitious

and will significantly overstate the likely fund accumulation.

What about a mix of funds which does not assume predominantly

equity-based investments, that is, a mix which is predominantly cash

or high-grade fixed interest? The range of 5, 7 and 9 per cent can

easily cope with all of these “what ifs?” but a standardised 7 per

cent growth rate cannot.

This is not progress. It prevents a good adviser doing his job

properly by highlighting to the client the most likely growth rate

appropriate to his or her particular investment mix. In fact, a

better argument could be made for introducing a fourth assumed growth

rate (probably 3 per cent – almost exactly the most appropriate cash

rate) than reducing the assumption to a single figure.

Well, forewarned is forearmed and we will just have to learn to live

with this problem and work harder to help clients understand the

importance of asset allocation and the realism of appropriate

projections.

Third, the interest rate assumption underlying the projected annuity

rate is to be the prevailing interest rate at the time of the

illustration. This is fair enough on the face of it but the most

important factor in the projection problems over the last decade

(that is, falling interest rates) has not even been addressed here.

Perhaps more helpful could have been a range of, say, three assumed

rates (perhaps 2, 4 and 6 per cent) to highlight the impact of future

changes in rates on the projected annuity rate.

I accept that such a move would potentially make illustrations more

detailed and potentially more confusing but this could have been

counterbalanced by more regular and comprehensive advice and

explanations from the IFA.

Finally, our friend from my last few articles – mortality. The

mortality tables to be used are 10 years old and, while some

allowance is made for mortality improvements, this is relatively

small compared with the potential future improvement, especially for

younger clients.

Advisers should be aware that a continuation of the improving life

expectancy of the last few decades could lead to significantly lower

annuity rates than those illustrated, requiring a much higher

accumulated fund to produce a required level of retirement income.

In my next article, I will move back to talk about the future for

final-salary pensions, particularly the implications for members of

those schemes.

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