A 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 [1] 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 [2] 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 [3] 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.
[4]
I’m the operator of a retirement calculator
I’m going to use Dinky Town’s retirement income calculator [5] because it gives me complete freedom to adjust the growth rates1 [6].
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]
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
[8]
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!
[9]
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 [10] 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 [11] or shave a little off his target retirement income [12].
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 [13] 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 [14] into equity overdrive. Afterall, much of the reduction in the pension forecast rates is due to low bond yields [15].
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 [16] 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 [17] 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
- The new FSA growth rate projections do not have to be implemented by financial firms until April 2014. [↩ [22]]