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What&#39s the frequency?

Over the first two articles in this series, I have started to look at important issues relating to assumptions which should be made when formulating and presenting a client with a report and recommendations based on specified levels of target benefit – these targets either to be set by or agreed with the client.

I have already identified the nature of a number of assumptions inherent in a target benefit-driven calculation and have discussed ways in which we can then determine suitable numbers to adopt for each of these assumptions. I will be continuing these discussions over the next few articles but, first, I would like to highlight one of the main messages behind this series.

It is not so much simply to outline the procedures in target benefit calculations. It is not even to identify and quantify the nature and level of the assumptions. Much more, it is to confirm that, whatever assumptions are adopted at the outset, it is almost certain that they will be proved incorrect over the coming years.

This inherent inaccuracy categorically emphasises the need – and starts to outline the nature – of a periodic review of the financial plan with the client. Readers should particularly bear this last point in mind as we progress through the remaining stages of our target benefit calculations.

We have already discussed the rate at which a specified target level of income should be increased over a period of time (that is, in line with expected price or wage inflation) to reach a revised target. An appropriate next step should be to deduct from this target income the level of income the client is already expecting to receive from that future date.

In this article, I would like to start with the determination of likely income from state pensions – both the basic state pension and Serps. A huge proportion of the population have accrued eligibility to benefits under the basic state pension, so that seems a sensible place to start.

Everyone who pays either Class I, II or III National Insurance for at least 10 years of their working lifetime will accumulate some level of entitlement to the basic state pension. Most financial advisers will have at least a rudimentary knowledge that, beyond this period of contributions, there is a sliding scale up to the maximum entitlement which arises after an individual has contributions or contribution credits covering at least 90 per cent of their working lifetime.

I would suggest that a more detailed knowledge or understanding than this brief summary is not essential for advisers as it is freely and easily possible to determine a client&#39s entitlement to the basic state pension simply by submitting DSS form BR19 to obtain a statement of entitlement.

I would like to focus on the relevance and use of the DSS&#39s reply to BR19 in our target benefit funding calculations, again looking at the variations which might occur over the coming years to the assumptions used in the initial DSS reply.

In fact, the DSS illustration of entitlement shows the accrued value of entitlement as a weekly amount, which is easy to convert into an annual amount, of course. For the purposes of target benefit calculations, it is important to note that the illustration is given in today&#39s terms, with no allowance made for the likely increase in the rate of basic state pension between now and the date the benefits are due to commence (from age 65 for most people).

This does not cause any concern if we assume that the level of basic state pension is, under current legislation and practice, increased annually in line with increases in the rate of price inflation – an assumption we have already determined how to quantify in previous articles. True, a future Government could change this rate of increase, introducing a second variable factor to this assumption (through legislative changes to price increase assumptions) but for the time being this should be a straightforward assumption to make.

A greater level of difficulty, though – and one which runs throughout our target benefit projections – is that the BR19 reply produces a level of annualised income whereas elsewhere in our calculations we are producing a future estimation of a capital amount. Thus, for example, if we are projecting the likely future value of a current invested lump sum of, say, £20,000, then we will arrive at a capitalised future value, not (at least directly) an annualised income. This will apply not only to invested capital but also to the value of pension rights within money-purchase schemes and to the likely maturity value of regular-contribution savings plans.

By contrast, other aspects of the financial plan, such as pension rights, will be expressed not as a capital amount but as an annual income. The decision must be taken at outset as to whether the calculations will all lead to an annualised income or to a capitalised amount at the specified future date.

How can this work in practice? If it is desired that the calculations will be made towards an annualised amount, then capital aspects of the financial situation must be converted. The basis for that conversion then forms one of the assumptions which must be made at outset and this should have regard to the basis on which the client considers he would like the income to be payable from that stipulated future date.

For example, if the client wishes to be presented with a target benefit plan expressed as an annualised amount, he must be encouraged to speculate as to whether he is likely to want that annualised amount payable on a level basis or whether it should escalate every year in payment. His answer will be significant. If he wishes his income to be on a level basis, then a conversion factor from capital to income might be (depending on sex and age) around 11 to one (that is, £11 of capital for each £1 of annual income). But if a fixed rate of escalation of 3 per cent is required, this factor increases to, perhaps, 14 to one, requiring more capital per £1 of income.

These factors are equally relevant if (less usually) it is determined to express the target as a capitalised amount, thereby converting future income streams – such as entitlement to the basic state pension – into an equivalent capital value.

Overall, for the purposes of an ongoing example, let us suppose that in this instanceit is desired to express the target benefit as an annualised amount. The basic state pension entitlement is already presented to us in this format and so requires no further calculations. What is required, however, is an understanding that this aspect of the client&#39s target benefit calculations will, in common will all the other aspects, require regular review. This review will take into account actual inflation figures each year (against assumed inflation in the original projection), new forward projections for inflation (from the gilt markets, as discussed in previous articles), further accrual of basic state pension entitlement and, possibly, legislative changes to the eligibility and accrual rules for basic state pension.

In this last category – legislative changes – it is often speculated that it may not be many more years before payment of part or all of the entitlement to basic state pension will become means-tested and that, perhaps, these future benefits should be excluded altogether from target benefit projections. This would be a dangerous stance to take for financial planners. It would be more prudent to include this entitlement in the calculations but point out the possibility of means-testing separately to the client.

Keith Popplewell is managing director of Professional Briefing


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