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