My wife has a workplace pension scheme set up by a tied adviser under the Royal London banner, (remember, the employee has little choice with workplace pensions). Her annual statement was received yesterday and, as usual, I was quizzed about what it all meant. Unfortunately, this was done with something of a head of steam, as the statement’s contents were not to her taste.
To summarise, she had paid in about £5,900, the current value was about £5,600, the projected fund value at 65 was about £97,000 and the annual projected income was £3,110. Her point to summarise it succinctly, was “why should I pay £6,000 a year now to get £3,000 a year in 12 years time!?”
Like so much in financial services, some things are not quite what they seem, but others things are exactly what they seem!
Take the £5,900 and the current value of £5,600, an explicit loss in the year of £300. This is a real loss, generated by poor returns in the short term and a product charge of 1%, rebated back to 0.75%. However, putting this into context, the FTSE has retrenched by about 8% in the last six months and this is a predominantly an equity holding. In that context, a loss of about 5%, (300/5900 x 100% = 5.03%), is within the bounds of acceptability. So long as we do not need to sell the holding now, it would be reasonable for us to anticipate a recovery of value then investment growth in the time scale anticipated.
Now for the projection of £97,000 at 65 years old, which is 12 years time. This is the product of another 12 x £6,000 = £72,000, add in the current fund value and an investment return of about £19,400 to reach the total. Is it reasonable? A little spread sheet work suggests the investment return is about 3.5%, with returns biased towards the later years, (obvious, in the context of compound interest), and not unreasonable, given the fund holdings and the investment projections declared by Royal London.
Now the retirement income of £3,110; this calculation is mandated by the Financial Conduct Authority and reflects the impact of inflation of 2.5% over the next 12 years. Neither Royal London or I can change this number as it is a statutory requirement but I can explain how it was created and what it is supposed to show.
People place an exaggerated sense of value on money held now and find it very difficult to understand the effect of inflation over time. If you were 65 years old and had £97,000 now and bought an annuity, you would get an income of about 5% or £4,850. Royal London are using an assumption of 2.5% inflation, so next year, your income of £4,850 would be expected to only buy goods to the value of £4,729, with every year going down a little more. I cannot match the Royal London figure of £3,110 in 12 years time, but I am not far away, so a minor reduction in the start figure or an allowance for the cost of annuity purchase could easily explain any difference.
So why should you put £6,000 away each year now to get £3,000 a year at retirement? (Rather than putting it into an ISA?)
- The £6,000 put away now did not cost you £6,000, as you got tax relief on the premiums, (and in this instance, some advantage from the salary sacrifice scheme). The actual take-home pay cost was more likely £3,900. To get £6,000 in value from a contribution of £3,900 is a good deal in anyone’s terms!
- The £3,110 per annum pensions income was not really that; it was the inflation-adjusted value of it in 12 years time.
- The pension income quoted is a sustainable income from retirement to your eventual demise at some indeterminable time in the future. An annuity places the insurance company on the hook from retirement to whenever! Some people will die quickly and others will hang on well past 100 years old. You get value by staying alive – if only to spite them!
- You do not have to buy an annuity; pension freedoms allow you to take the £97,000 as cash in 12 years time, paying the tax due or take a drawdown income. A sustainable income at today’s rates would be about 4%, say £3,880 per annum and you would still retain access to the capital.
- An ISA really would cost you £6,000 per year! If you were using modern products, it would probably share the same investments and charging structure as the pension, so the investment performance would be very similar. It would just cost you £2,100 a year more.
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The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.