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Has the FSA just dropped a bomb on your pension forecast?

happy retirement cruising the world for new tea and cake experiences rests to a critical degree on the growth rate your investments enjoy in the meantime.

So it was with a nervous shudder that I greeted news that the Financial Services Authority (FSA) is cutting the projected growth rates used for pension forecasts and other investments.

The new annual growth rates are:

  • The nightmare scenario: 2%
  • The new normal scenario: 5%
  • The dream scenario: 8%

That’s a drastic downgrade in comparison to the previous middle and low-end projections of 7% and 5%. The upper end was previously 9%.

If you’ve used a UK-based retirement calculator to create your own personal pension forecast, then its growth assumptions are probably based on the FSA’s projected returns.

Which makes previous plans as over-optimistic as your mum on exam day.

A dose of realism

Numerous commentators and academics have warned that the damage inflicted by the Credit Crunch has created a new, low-growth world.

They estimate that future expected returns are unlikely to live up to the long-term historical averages when developed economies must grapple with:

  • The debt hangover
  • An aging population
  • Permanent damage to productive capacity
  • Tighter credit conditions

Sluggish equity returns and abnormally low bond yields may afflict portfolios for the next 10-15 years according to the research commissioned by the FSA.

True, these stunted growth rates are only projections. They are not destiny. But failure to review a plan before a sunny forecast turns to rain is a classic financial mistake.

So let’s break out the ol’ retirement calculator to find out what adjustments may be required now – rather than storing up the shocks for later, endowment mortgage style.

Stunted growth rates delay retirement day

I’m the operator of a retirement calculator

I’m going to use Dinky Town’s retirement income calculator because it gives me complete freedom to adjust the growth rates1.

This particular pension forecast will be made on behalf of jobbing illustrative anyman, Dangerous Dave.

Dave is:

  • 40-years old
  • Retires at 65
  • Invests £400 per month (including employer match)
  • Wants £20,000 annual income in retirement (after tax, and in today’s money)
  • Has £60,000 already in the pot

We’ll use an inflation rate of 2.5% in line with the FSA’s forecast.

I’m assuming that the new growth rates hold true for the remaining 25 years of Dave’s pension accumulation phase.

7% growth rate – The good old days

 

7% projected return

In the glory days of 7% returns, Dave’s predicted retirement income would have been just over £20,000 after tax and inflation.

Now let’s see what happens as the global gears grind and growth slows to 5%.

5% growth rate – Life in the slow lane

 

5% projected return

5% growth only delivers an annual income of £14,687 after tax, with all other assumptions remaining the same.

That’s a cut of over 25%.

I think it’s safe to predict that 2% growth is going to be horrible…

2% growth rate – NO! NOOO!

 

2% projected return

The £20,000 a year dream has been smashed. In this reality, Dangerous Dave can only scrape up £9,420 a year. His income will be less than half of what he hoped for.

The good news: Dave won’t pay tax on that.

Pay now, buy later

Evasive action is required. Assuming the FSA’s new projections come to pass, how much extra does Dave need to invest in order to hit his £20,000 target by age 65?

At 5% growth – Dave needs to up his contributions from £400 to £700 a month. That’s an increase of 75% and stiff medicine.

Alternatively Dave could plan to retire later or shave a little off his target retirement income.

At 2% growth – Dave must put away £1,220 a month to hit £20,000 in 25 years. That’s an increase of 300% and just not possible as Dave’s income is squeezed from all directions.

Assuming £700 a month is the best Dave can manage, then he will eventually retire on a little over £16,000 a year if he delays retirement to age 70.

Here’s hoping that prolonged 2% growth proves to be no more than a bad dream.

What a state

I haven’t included the state pension allowance in any of Dave’s sums, and that could brighten the picture considerably.

I think of the state pension as a fallback position if the plan goes awry:

  • If growth is even lower than I’m allowing for.
  • I can’t work for as long as I hoped.
  • I’m not able to contribute as much as I wanted to.
  • Retirement expenses are higher than I’ve estimated.
  • The tax position is worse than expected.
  • I live for a very long time.

That’s a lot of reasons to keep something in reserve when doing your projections.

Dave won’t even qualify for the state pension until he’s 67. Moreover it’s a brave pundit who forecasts what it will be worth in 2039.

Taking stock

Another option I haven’t explored is throwing Dave’s asset allocation into equity overdrive. Afterall, much of the reduction in the pension forecast rates is due to low bond yields.

However the research is based on a standard issue portfolio that already devotes a fair wedge to equity (including property):

  • 57% equity
  • 10% property
  • 23% government bonds
  • 10% corporate bonds

The report actually forecasts a return of 6% for this portfolio, though it makes no mention of fees.

Most investors should probably round down to 5% to account for the finance industry’s nibble. Careful passive investors should get away with losing only 0.5% to fees.

Upping your equity allocation is therefore a potential solution but one that courts disaster if you’re ignoring the limits of your personal risk tolerance. Will you be able to control your flight reaction when the market crashes and your future is staked on nose-diving equities?

Increasing your equity allocation also increases the risk of a rare but terrible outcome – you can get a sense of this by stress testing your retirement plan with a Monte Carlo simulator.

Steady as she goes

It’s impossible to contain all the variables in play and also I’m glossing over the fact that, in my personal circumstances, inflation has outstripped my stagnant salary and pension contributions over the past three years.

The best you can do is to keep running your own pension forecast numbers every year and correct course as you go.

You can always ease off the gas later, should it turn out that you’ve over-compensated, or the dire forecasts failed to predict the invention of cars that run on bullshit.

At least any pain taken now will be partly anaesthetised by increased feelings of security, and visions of your future-self sending you a congratulatory telegram back through the time-post.

Take it steady,

The Accumulator

  1. The new FSA growth rate projections do not have to be implemented by financial firms until April 2014. []

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{ 16 comments… add one }
  • 1 ads November 6, 2012, 2:50 pm

    Makes me yearn for a guaranteed public sector pension !

  • 2 ermine November 6, 2012, 4:25 pm

    the magic of compound interest eh? Don’t rely on it to do ‘owt other than compensate you for inflation in tomorrow’s desperate times…

    Compounding roughly doubled the real value of your pension pot at retirement over a 30-40 year working life. That lent (limited IMO) credence to the view that you needed to start early.

    If the kibosh is put on that, then it doesn’t matter when you do your saving – either slow and steady throughout your working life, in a mad rush at the beginning (footballers and sportsfolk generally, city traders before burnout etc) or in a mad rush towards the end, when you are more likely to be a HRT taxpayer, more in a position to save and closer to the goal… It isn’t all bad, and indeed favours unusual options like extreme early retirement.

  • 3 robmatic November 6, 2012, 10:45 pm

    Overpayments on a post-credit crunch mortgage are quite likely to beat the new mid-range return on a pension*. Surely this makes it difficult for a financial adviser to recommend taking out a personal pension or making additional pension contributions? Although I’m not sure where they will draw their 0.5% p.a. advisor fee from if they do this.

    *APR on a 90% LTV seems to be about 5% at the moment.

  • 4 Rob November 6, 2012, 11:38 pm

    4% equity dividend yield from equities is a good start.
    It is hard to see any form of fixed income investment delivering decent returns in nominal terms, let alone real after inflation.

  • 5 ermine November 7, 2012, 11:29 am

    Overpayments on a post-credit crunch mortgage are quite likely to beat the new mid-range return on a pension

    Doesn’t this depend on the tax rate differential between paying in and out of the pension? HRT payers get a 22% boost on that, upping the 5% return to a 6% return ‘cos you have more capital to get a return on. And they might get a retaining child benefit bonus too. A BRT payer paying via salary sacrifice gets a 32% boost on the way in due to saving NI payments and a hit on the way out from 0-20% depending on how much their pension is over the personal allowance.

    There are other good reasons for paying down your mortgage, particularly if you’re still working by the time you’ve done it and can hit the pension contributions hard with the money you don’t need to pay on the mortgage. But the pension still carries it, just. When interest rates go up that will all change 😉

  • 6 HHR November 7, 2012, 11:45 am

    thanks for the great post.
    might be a stupid question: why did you leave the taxes as 0% in your input? i don’t understand why the retirement tax would be 0%.
    what am i missing? cheers

  • 7 Stuart November 7, 2012, 5:55 pm

    A year a go I left a perm role with in an Investment Bank (and my pensions) and set up a as a contractor. having looked through several Pension plans I came to conclusion (returns, costs, future uncertanties) I would be better of filling up my ISA with passive Index fund and paying of my mortgage early. Then ramping up my savings across different sectors, post mortgage freedom. Unless you are a HRT payer with kids (thanks to our PM), I’d give pensions a wide birth (IMO) .

  • 8 The Accumulator November 8, 2012, 10:08 pm

    @ HHR – It was easier for me to set the retirement tax rate at 0% and plug the clean figure into Listen To The Taxman to find the after-tax income.

    Re: pensions – there is also the lure of employer match, 25% tax free and the fact that you can’t just dip into it when you fancy.

  • 9 robmatic November 9, 2012, 1:03 am

    @ Ermine

    Personally I don’t think the tax advantages of a pension are that great given the restrictions. Here we seem to be talking about the pension contributions (according to the FSA mandatory illustration rates) only just being more effective than mortgage overpayments despite the assumption of much more investment risk. My point really is that for people in an advice situation who express even a moderately cautious or risk-averse outlook – should the advisor be recommending a pension over the alternatives?

    I also view mortgate overpayments as being fairly effective anyway in terms of ‘tax relief’ as the savings that you make on servicing the interest boost your after tax income.

    Although I guess I should point out that personally I am happy with my own pension, but it’s because of the salary sacrifice, 10% employer contribution and 0.45% TER, and because I have a high tolerance for risk.

  • 10 The Investor November 9, 2012, 8:41 am

    I agree that mortgage over-payments are an effective form of tax-free savings, though I’m not sure I’d be rushing to do them now with the best fixed rate mortgages below 3% — almost free money. Even the FSA thinks you ought to expect to do better than that most of the time!

    The tax-free nature of owning a home in the UK is a huge perk that, coupled with cheap financing, has made most ordinary people most of any of the money they made. I dread to think what would have happened over the years if they had to buy a mortgage via a fund manager — 2% in annual fees and moving house every six months as they play the market I suspect. 😉

    The downside is an enormous lack of diversification in putting all your eggs in one basket — your home. Plus shares have done better than even UK housing over the long-term (but they’re far harder to gear up with (happily)).

    I think a mix is best (and I say that having suffered at the hands of not owning a property — long story, elsewhere on this blog). Definitely agree you should fill your ISAs if possible, not least because you can’t ever get each annual allocation back. Pension benefits are undoubtedly greatest when a higher-rate tax payer or if you run your own limited company or similar.

    One could always fill up the ISAs and then as/when/if you find yourself a higher-rate tax payer (and/or get closer to retirement) and the situation with pensions is fairly clear (as the years exposed to meddling by governments are reduced) you could make substantial pension contributions from the ISAs to the pension it looks a profitable deal.

  • 11 HHR November 9, 2012, 11:45 am

    Hi Investor
    what do you mean by “the tax-free nature of owning a home”. why is owning a home tax free?

  • 12 The Investor November 9, 2012, 4:59 pm

    @HRR — You pay no capital gains tax on a home. Nearly all other investments incur capital gains tax unless in shelters like an ISA or a pension.

    When you consider the gains that say a 60-year old likely made on their property (10-fold wouldn’t be pushing it) it’s a very significant tax advantage.

    You could also argue that there are built-in advantages (you effectively pay yourself rent for the ‘service’ of living in your home, versus a landlord who would have to pay tax on any profits after costs) but that’s a bit more esoteric. I more meant just the capital gains angle.

  • 13 HHR November 9, 2012, 5:47 pm

    ah, of course! thanks for taking the time to explaining that to me.

  • 14 Daytona November 9, 2012, 8:17 pm

    Since the average return on equities over the last 110 years or so that data is available has been 5% real, that’s what I’ve always used.

    Due to the restrictions and risks involved with pensions, I do not believe that they are a good idea for standard rate taxpayers; ISAs or direct holdings are better.

    I gave up contributing to pensions when Labour retrospectively changed the retirement date to my detriment.

  • 15 Jonathan May 9, 2013, 9:01 am

    Are these FSA rates of return real or nominal?

  • 16 The Accumulator May 9, 2013, 1:13 pm

    Hi Jonathan, those are nominal returns.

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