Go with the flow

Go with the flow

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?

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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.