Planning some way into the future unfortunately involves making quite a lot of assumptions. And by the nature of long-term planning, small changes to those assumptions can make a big difference to the final outcome.
For those trying to plan for a retirement 20 or 30 years into the future, the main questions they are trying to answer are, ‘how much to save now?’, ‘in what vehicle?’ and ‘at what level of risk?’
To answer they have to make a handful of key assumptions and also factor in all income variables. One of the main variables – which has just changed – is the state pension, which is an often overlooked but vital part of retirement planning. So what do the state pension changes mean and what are the key assumptions planners need to make?
New pension levels
Firstly, the old two-tier pension system was scrapped in favour of a single state pension from April this year. The single pension is now worth £8,092 a year, but this will rise in line with inflation at a minimum of 2.5 per cent a year under the triple lock promise (the level will be the higher of wages, CPI price inflation or 2.5 per cent). Inflation might be currently negligible (CPI was 0.3 per cent in February 2016), so the triple lock is certainly worth having.
To put this in perspective, however, the long-term market assumption for inflation is 3 per cent (the 20-year break-even rate between inflation-linked and fixed-interest government bonds).
The reason why all this matters is that making an allowance for inflation is one of the most important – and trickiest – assumptions. Most standard models use a 2 per cent inflation assumption (the government’s target level). But growing at 2.5 per cent, the £8,092 a year state pension will grow to at least £17,000 in 30 years’ time. To put this in perspective, a client would need approximately £180,000 to buy an equivalent annuity in the market at March 2016 prices, so it is an important consideration.
To complicate matters, those who have already built up a state pension under the old system, which is higher than the new single pension, will receive this instead. Trying to work out whether your client has achieved this is fiendishly complicated, but those retiring on a maximum pension under the old system will be receiving roughly £14,500 in 2016, which is considerably higher than the new flat rate.
Anyone who has made National Insurance contributions for more than 10 years could be in a position to receive a boost to the new flat rate.
The test is, which of the two is higher at retirement – your old system pension accrued up until April 2016 plus the new flat rate from then on, or the flat rate as if that had been the system all along?
Given the margin of error involved with making detailed retirement plans 20 or 30 years into the future, it is probably not worth anyone’s time trying to calculate this accurately decades in advance. So the first assumption should simply factor in income of £8,092 a year, inflated by 2.5 per cent a year until state retirement age (which is likely to be 67). More cautious planners will push out the expected state pension age to 68 or even 70 for a 35-year-old today, given the direction of political travel.
Calculating total income
So that’s one income assumption covered. The client then has to work out total income from other reasonably predictable sources, such as defined benefit (DB) pensions. A DB pension statement should give an income estimate with or without tax-free cash – this also may need to be adjusted for inflation.
The retirement date is likely to be earlier than the state pension age – most frequently 65. That’s the easy bit done.
The tricky bit is then working back from a desired level of income to the total amount currently invested in defined contribution occupational or personal pensions – and seeing what the gap is. Again, the desired level of income needs to factor in inflation, as well as any other likely sources of income. It also needs to take account of the cashflow gaps between DB pension retirement date, state pension age and the desired retirement date. That could mean the client needs a higher level of income in the first few years until their other pensions kick in.
Inflation issues
Don’t forget either that state and DB pensions will increase with inflation after retirement – and that drawdown income will need to rise with inflation otherwise its real economic value will fall.
It may help to work out the total expected level of income for each year of retirement in today’s economic terms (so discount the amount by your inflation assumption for each year between then and now).
Assuming the projection is based on the client taking drawdown rather than buying an annuity at retirement, another key assumption is how long the client needs drawdown income before the pot is exhausted. This calculation also needs a conservative assumption for the investment growth in the drawdown pot. Life expectancy from age 65 is roughly 18 years for men and 21 years for women – but these assumptions are likely to be revised up for younger clients.
The client should also consider the question of whether their income needs will diminish as they get older, and whether they want to leave a pot at the end to be inherited.
With all these variables defined, the adviser can then work back to contribution rates required at different growth assumptions based on the amount already built up in defined contribution pots. Advisers will find that tiny changes to any of the assumptions will come out with widely different answers. But unless the client goes through the process thoroughly they cannot have a meaningful retirement plan.
Importantly, clients will need to review the assumptions in light of reality at regular intervals to ensure the plan remains on track.
All this involves detailed cashflow planning and fairly sophisticated modelling tools. But if it were easy, the client would not need their adviser. In fact, this cashflow planning service is just as important, if not more so, than the product recommendations that have traditionally been the focus of advisers’ attention.
Bob Campion is head of institutional business at Charles Stanley Pan Asset
