In my last article, I started to look at the use of target benefit projections in giving financial planning advice, particularly investment portfolio advice, inside and outside of pension contracts. I discussed the projection of a required income level using either price or wage inflation and posed the question: “What is the likelihood that the rate of price or wage increase we originally decide upon will materialise exactly over the next 20 years?”
Having determined the rate at the outset – primarily by reference to the redemption yield on fixed-interest and index-linked gilts – the answer must surely be that there is very little likelihood that our original projected rate of increase will actually come true, for a number of reasons.
First, redemption yields on Government bonds only reflect the rate of increase expected by (primarily) institutional investors. They should not be taken to be an accurate, scientifically calculated assessment. Moreover, these Government bond markets frequently become distorted by factors other than pure economic outlook – recent examples being a surplus demand for fixed-interest gilts from final-salary pension schemes striving to comply with the minimum funding requirement.
Second, expected rates of price inflation can change dramatically due to a wide range of economic influences, including influences sometimes beyond the control of the UK – for example, substantial increases in the costs of production, including oil and raw manufacturing materials.
Third, when projecting forward at the rate of expected wage inflation, our original projection could not only be thrown by variations in the rate of price inflation but also by the client's individual rate of wage rises, which might not match the national average.
So, having suggested a means by which a projected rate might be decided upon, and having started this article by suggesting that the original rate is highly unlikely to be proved correct, perhaps one could be forgiven for suspecting that there is little point in attempting any projections in the first place.
In fact, any attempt at projected benefit planning advice requires assumptions to be made from the outset in the almost certain knowledge that some, most or all these assumptions will be proved incorrect over the course of time.
This requires the acceptance by both the adviser and his client that the entire financial plan must be reviewed regularly – probably every year – not only in respect of investment fund performance (an issue which is usually well dealt with by most advisers) but also in respect of these other assumptions.
A simplified continuation of our example from the first article should help illustrate this point. In that example, we were gioven the task of producing a level of income of £20,000 a year, in today's terms, starting in 20 years time. We estimated (from the Government bond market) that price inflation will rise over the next 20 years by an average of 2.25 per cent a year, requiring a true level of future income of £31,210. Now, let us suppose that we revisit this assumption after one year. Two aspects should be addressed:
What has been the actual rate of price inflation over the last 12 months?
What is the future rate of assumed price inflation over the next 19 years (again, derived from the Government bond redemption yields at that time).
As an example, if the rate of price inflation over the first year has been 4.25 per cent, not 2.25 per cent, then the projected income need of £31,210 a year should be increased by 2 per cent. This might not appear to be a major amendment and, of course, in itself it is not. However, it should be easy to see how each year's amendment can make a substantial difference when accumulated up to the end of the period and, without such regular amendments, the client's initially calculated target income could be in very real danger of falling well short, in real terms, of what he had hoped.
Next, at the end of the first year we should revisit the Government bond markets and reassess the expectation of future inflation. If that expectation has increased from our original rate of 2.25 per cent to, say, 3.25 per cent, then the target income requirement should be increased accordingly, broadly, by an extra 1 per cent a year for the next 19 years. You should be able to see immediately that even small movements in the future expectation of inflation can make a huge difference to the client's future target.
Similar considerations should be taken into account where the client's future target has been agreed in terms of future wage increases except that, besides using the Government bond market's expectation of inflation, adjustments must be made for the client's true rate of wage increase over the first year and any amended expectations he now has for the future, for example, a more enthusiastic expectation of above-average wage rises.
In summary, the original plan must be reviewed at regular intervals – most typically on an annual basis. The reasons for the need to conduct these reviews should be explained to, and understood by, the client from the outset.
Moreover, and extremely importantly, both the adviser and the client should understand that this review should not be conducted purely for technical reasons. The amendments made to the target level of income will obviously have an impact on the level of investment the client must make to produce that income.
Thus, in our amended example, where the rate of inflation increases above the original assumption, the target level of income might have increased by about 20 per cent over just one year, resulting in a requirement for the client to make investments 20 per cent higher than the original plan.
The client should be aware from the outset that this possible requirement for increased investment may come not from poor investment performance but from factors beyond the control of the adviser (in our example, increasing levels of price inflation).
So we start to move on to the next stage of our target benefit calculations, having determined the target level of client income, after adjustment for inflation or wage increases and agreeing with the client the need for regular reviews.
The second stage should be to deduct from this target income the level of income the client is already expecting to receive from that future date. This seems obvious but in my next article I will be looking at some particular examples of this stage which I believe do not often receive an appropriate level of attention by some advisers.
The examples that I have chosen are:
Likely income from state pensions (basic state pension and Serps).
Income from final-salary pension schemes (both current and relating to previous employments).
Income from money-purchase pension schemes.
Income from other types of investments.
You might want to give some thought to the different assumptions which will have to be made in determining the levels of income from each of these different sources, distinguishing (to give you a clue) between sources which may be identified as directly producing income from other sources which produce a fund which must be converted into an equivalent income.
You might also give some thought to the sources of the information we will require to identify and quantify the value of these sources.
Keith Popplewell is managing director of Professional Briefing