FOOL'S EYE VIEW
How To Understand Your Pension Statement

By Stuart Watson (TMFTiger)
January 21, 2002

Great Titchfield Street, London -- Last week I received a very important letter, crucial to my future financial well-being. However, it was so unclear it might as well have been written in Chinese. It was my annual pension statement from the Permanently Improvident Assurance Company.

I got this policy when I was working in my previous job and I no longer make contributions to it directly, as I find ISAs more suitable for my own retirement planning at the moment. However, I have contracted out of SERPS so the annual payments into the fund from this should enable the policy to mature into a significant sum by the time I hang up my jester's cap for good. Like many, I've always had a quick glance at this statement, but never looked in enough detail to see where all the figures come from and, more importantly, whether they actually made any sense.

The statement runs to four pages in all. The first and last are straightforward enough, showing stuff like the current value of my fund, what has been paid in over the last year and which of their funds my money is invested in. It even has a transfer value showing how much money I would be able to transfer to another pension company, should I choose to do so.

The performance of the fund over the last year is hidden though. I have the number of units and the fund value but I have work out for myself that this means that the fund dropped some 10% (which is about average as it happens). There is not a peep about charges either. There's a link to the fund information on their web site and the information isn't provided there either. That is an absolute disgrace considering the relevance of this information to my eventual pension income.

It's the middle two pages that cause the most confusion though. These contain the "Illustration of your future pension benefits". It runs to two pages in my case because I have one for the fund built up from my own contributions and one for the fund built up from the money I received from contracting out. Both contain some assumptions and then some tables with the projected benefits.

Whilst the statement lists some relevant assumptions, it is missing some key ones too. It's also not clear how most of the assumptions are derived (particularly in the table), so it's hard to see if they are applicable to you, or whether you may need to tweak them. When you're making projections for a couple of decades (or more), even relatively small changes in the assumptions can have a large effect on the final results.

Here are the basic assumptions, as listed on the statement:

1. The pension is paid monthly in advance
2. No further contributions are received
3. The pension will not increase
4. The pension is payable for life

Here is what they mean:

1. As this is a personal pension, at some point before I'm 75 according to the current rules, I will have to convert the fund I've built up into an annuity, which will pay a pre-determined income for the rest of my life. So when they say "pension" in these assumptions they actually mean "annuity income". They've assumed I will get this money monthly in advance (fair enough).
   
2. I won't pay any further sums into my pension. This may or may not be the case with regards to my own contributions but I know I'll continue to get some money paid in each year because I have contracted out of SERPS. This means that any illustrated income will be less than it should be. A glance back at my previous statements shows that when I was paying my own money in, they assumed these contributions would continue at the same rate until I retired. In reality I would have increased them in line with inflation or more each year, also meaning the projected pension would be underestimated.
   
3. They assume that I will get a level annuity and not one that increases in line with inflation. With retirements lasting 20 to 30 years I would want some inflation protection. As a 65-year old man I would currently be able to get a level annuity of 8% to 8.5%. One that was inflation-proofed would be around 6.0% to 6.5%.
   
4. So my pension will die with me (a single annuity). It wouldn't be paid until the death of both myself and my spouse (a joint annuity). If I wanted a joint inflation proofed annuity I would be looking at a rate of around 5.0%.  (You can find other current annuity rates on web site such as this.)

Straight away you can see that some assumptions will underestimate my income and that others will overestimate it. The net effect of these might be to cancel each other out. But that's fairly unlikely. Whilst I can make some adjustments myself, like a lower annuity rate, working out the effect of further contributions will require a detailed spreadsheet or a lucky guess.

If you're thinking that the final figures won't be much use at all then you're probably not the only one! But until you understand how they are built up it's difficult to know for sure. Interpreting the projected numbers in the table is an article in itself, so I'll complete this story tomorrow.

More: Pensions Centre