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Value-added facts

I have been outlining certain aspects of target benefit-driven financial planning recommendations, where a client is encouraged to quantify the level of income he will require from a specified date in the future.

After establishing a target level of benefit, which in earlier articles we have uplifted to take account of the assumed future effects of inflation, we can consider what other forms of future income or capital there might be to deduct from this target figure.

Having focused our attention on the various forms of entitlement to state pensions, I moved on last time to private pension arrangements, starting with the value of preserved pensions in a final-salary scheme.

More problematic than the value of an early leaver&#39s pension in a final-salary scheme is the expected value of a current member&#39s rights in such a scheme. It must be determined – almost certainly with guidance from the client – whether we should take into account only the value of the pension rights accrued to date or to assume that employment and, therefore, membership of the scheme will continue to the scheme&#39s normal retirement age.

The former assumption is more appropriate if the client feels that he is likely to leave his current employment in the not-too-distant future while the latter assumption is more appropriate if the client feels that he is more likely to remain with his current employer for many years to come.

If it is decided only to take current benefits into account, the calculation is simple. The scheme benefits&#39 accrual rate can be applied to the client&#39s current pensionable earnings and, as we are to treat him as a likely early leaver, this benefit may be projected to his target benefit age in line with expected rates of average price inflation.

For example, Fred, whose current salary is £30,000 a year, is aged 45 and has worked for his employer for 10 years, being a member of a 1/60th final-salary scheme. The scheme pension age is 65. Thus, Fred&#39s accrued pension rights are 10/60ths of £30,000, that is, £5,000 a year. Projecting this forward to the scheme pension age in line with expected price inflation at, say, 3 per cent a year, this indicates a likely future pension of £9,030 at age 60.

This assumption of early leaving obviously errs on the side of caution as Fred may well stay with his employer for many years to come. Thus, a more realistic approach may be to assume that Fred will continue to accrue benefits.

In our second example, Fred assumes he will stay with his employer until retirement age. This indicates that his final pension will be 30/60ths of his final salary. To estimate his final salary, we should increase his current salary of £30,000 a year by an assumed rate of future wage increase. If we take that rate to be, say, 4 per cent a year, this indicates a final salary of £65,720 a year and so, taking 30/60ths of this figure, we can project a pension from age 65 of £32,860 a year.

Whichever assumed pension figure is to be used, this should be deducted from the client&#39s target income from age 65, along with his projected entitlement to state pension benefits, to arrive at his anticipated shortfall.

However, as I have noted in previous articles, a crucial aspect of target benefit-driven financial planning is the acceptance that the assumptions made at the outset of the strategy will almost certainly prove incorrect as the years progress. A regular review should include revisiting prior assumptions to revise future projections.

In Fred&#39s example, one year on, we will reconsider whether he will continue to work for his employer. We will also look at the rate of increase in price or wage inflation (as appropriate to our initial assumptions) over the last year and revise our assumptions for the future. The revision of future assumptions will depend primarily on the redemption yields from Government bonds at that time, as I have outlined previously.

Having concluded our look at the projected future value of final-salary pension benefits, we can turn our thoughts to the projected value of money-purchase scheme benefits. These projections involve a totally different set of assumptions than those we have used for state and final-salary pension benefits and give me the opportunity to stress once again that much of the skill involved in target benefit planning is the identification of the appropriate assumptions and the estimation of an appropriate rate for each of those assumptions.

As regards money-purchase benefits, we are, of course, working with a fund which we then have to turn into an assumed level of annual income. The main factors we have to take into account are:

•The current value of the accumulated fund, if any.

•The time to the projected pension age.

•The rate of growth on the accumulating fund.

•The likelihood of future contributions, if any.

•The annuity rate to be applied to the projected fund.

The value of the accumulated fund is easily determined from a recent benefit statement. The time to the projected pension age is also a factor which is easily calculated.

More problematical and debatable is the assumed future rate of investment growth. The adviser should not simply use one assumed future investment growth rate for all clients. It is essential that the assumption should be driven by the asset allocation within each client&#39s pension fund.

If the client&#39s fund is placed entirely on deposit or in some form of cash fund, then the rate of return to be assumed should not exceed that available on the money market from short(ish)-dated deposits – perhaps no more than 4 per cent. If the client&#39s fund is invested in a long-dated gilt fund, then the appropriate rate would be the redemption yield on those gilts (a little over 5 per cent a year) less, where appropriate, an allowance for fund charges.

Corporate bond fund returns will depend on the quality of bond held within the specific fund – high-grade bond funds should return, say, 1 per cent over equivalent gilts, so we may assume a 6 per cent yield, while lower-grade bond funds might return around 3 per cent over gilts, indicating an 8 per cent yield, although that could be considered adventurous as some allowance should arguably be made for defaults, reducing this fund yield if considered appropriate.

Expected equity returns are highly contentious but may range from 7 to 10 per cent, depending largely on whether to approach the assumption from a yield gap with fixed-interest gilts, where the historical gap of 3 per cent year would indicate future returns of 8 per cent, or from expected future earnings growth on equities. Here, I will for now assume 9 per cent growth (without wishing to be contentious). I am also tempted to assume a similar return from property.

Most clients will invest in a variety of these asset classes, often through some form of arrangement such as a with-profits or managed fund. Calculations of assumed future growth rate can get very complex but may be illustrated in a simple example (see below) which would indicate a reasonable overall assumption of 7.7 per cent for this mixed fund.

Next time, we will start to apply these assumptions to the remaining factors of assumed annuity rate and assumed future contributions.

Keith Popplewell is managing director of Professional Briefing

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