The other day a prospective client dropped me off some information on his pensions. The first page made my heart sink, so much so I tweeted my despair and decided to blog/video to try and help educate people, so hopefully their hearts don’t sink too.
What was on this paperwork which could possibly be so offensive I hear you ask? Well, it was this…
If you are not sure what that is, let me explain. It’s a current value of a pension pot with a projected value in 5 years’ time. It’s little wonder that pensions get negativity from the general public with information like this. You invest your money for 5 years and get back £1,000 less than when you started. It’s hardly going to have them queuing round the door is it, but before we dismiss pensions as pointless, a comment I frequently hear, let’s dig a bit deeper into those numbers.
First off, let’s not blame the pension provider, well, we can blame them a bit for not providing more details on how those figures are calculated, but they have to use certain assumptions as laid out by the Financial Conduct Authority ‘FCA’. They must provide projections using three separate growth rates, 2%, 5% and 8%. The FCA has also stated these should be lowered if the pension provider feels the standard rates overstate the potential for growth.
Pensions Growth – The Calculations.
The provider begins by calculating the estimated returns for each asset class, let me explain that in more detail. It is reasonable to assume cash as an asset is going to return far less than equities over the long-term. So having a lower assumed rate for cash is a sensible assumption. They do the same for all the other asset classes e.g. commercial property, fixed interest securities and government bonds. These rates are then applied to the investment portfolio. Someone holding 50% cash will have a much lower projected growth rate than someone with 100% equities, hopefully, you get the picture.
It is important to note, that once the growth rates are calculated they are then adjusted for inflation, so any figures you see are in today money.
What Numbers do they use?
Let us use the example which made my heart sink initially and look at how they got to those figures. Firstly, they have used their lowest of the three growth rates for that portfolio, which is around 2.5% and have adjusted that for inflation assuming 3%. Which gives a negative real rate of return of 0.5%. You might be wondering why they are so cautious, well if you speak to anyone who had an endowment in the 1990s, you will understand. They would rather be cautious, and the growth exceed their estimates than vice a versa.
But these projections are designed to be cautious and, it is not unreasonable to expect a medium risk portfolio to give a better return over a long-term. Einstein famously said compound interest is the 8th Wonder of the World. It takes little additional growth over the longer-term to make a significant impact on the end value. Remember that the value of your investments (and any income from them) can go down as well as up.
What about the Income?
Underneath the projected fund value pension providers also give you an estimate of the likely income your pot will produce. This is where things get the most disappointing. Once again, the providers must use certain assumptions. Firstly, they assume that you will purchase an annuity with your fund. While this is still the first option to consider because annuities are based on the interest rates of Government Gilts (which are at rock bottom and have been for several years) it compounds the effect of low growth rates. You can find out more about pension income options in our last video Retirement Income – Make the most of your savings.
Review your Pensions!
When you next get a pension projection, do not despair at the projected values or income. While it can’t be said they are the worst-case scenario, the lowest rates are extremely conservative, and the income is based on the worst gilt yields in history.
If you have pensions that you don’t understand, you’re not sure how they are invested, what risk level you are exposed to or the charges you’re paying, 4 Financial Planning offers a pension review service which answers those questions. You can book an initial consultation using this link.