FOOL'S EYE VIEW
How To Understand Your Pension Statement (Part II)

By Stuart Watson (TMFTiger)
January 23, 2002

Great Titchfield Street, London -- Yesterday, I wrote a piece looking at how to interpret your pension statement, using my own as an example. Today I'm going to complete the story, using some cunningly disguised numbers regarding the value of my pension.

If you recall, the key part of the statement is the "Illustration of future pension benefits". Having digested the basic assumptions, I'm left with two sets of tables showing the projected fund value and the income that this might produce. It's the second of these sets that is of most interest because this is the one that has the figures in terms of current spending power by using real returns (i.e. adjusted for inflation).

Illustration 1
Annual Investment Return          9%
Annuity Rate                      8%
Inflation                         6%
Projected Fund Value        £28,710
Project Annual Pension       £2,425

Illustration 2
Annual Investment Return          5%
Annuity Rate                      4%
Inflation                         2%
Projected Fund Value        £29,040
Project Annual Pension       £1,620

In the first lot of figures it's been assumed that my pension will grow at a real rate of 2.8% (1.09/1.06). In the second illustration it's much the same -- 2.9% in fact (1.05/1.02). So that's why the project fund value in today's terms is rather similar. When I redid the calculations myself I found, with a little trial and error, that the actual increase used was nearer 2.4% in both cases. I'm guessing that the difference comes from charges on the fund. That would imply charges of around 0.5% a year, which doesn't sound too unreasonable. Unfortunately, I'm left with a suspicion that the charges actually come out before the investment return. On any basis, it would be nice not to have to guess about these things.

A check of the Permanently Improvident Assurance Company web site reveals that around 80% of my fund is invested in shares and the remaining 20% is in bonds and cash. I know that shares have historically returned 8% before inflation and that, for bonds and cash, the figure is nearer 2%. So, I would expect the fund to return about 6.8% above inflation with this asset mix. Therefore a real return of under 3% seems quite harsh over 20 years. Using a rate of 5.0% (I'm taking the average of the two to be conservative) I see that my final fund would be nearer £48,000 instead. If I were also to take account of more money coming in from my being contracted out of SERPS, the final sum would be higher still. 

The annuity rates also need closer inspection. You might recall from yesterday's article I reckoned a rate of 5.0% would be about right for me, being an inflation-proofed joint annuity. 5.0% of £48,000 is actually £2,400 a year. (You may also have noted that for some peculiar reason - answers on a postcard please - the quoted annuity rate used in each table don't seem to correspond with the numbers. In the first example I make it 8.5% rather than the quoted 8%. In the second I get 5.6% rather than 4%. I think I'll stick with my own homemade calculations!)

So where does this leave me? The first of the two pension illustrations is almost exactly the same as my homegrown calculation. The second is some 32% lower. Taken together the two give a reasonable range, but it's more by luck than judgment. A low investment growth rate was offset by an unrealistically high annuity rate. If I want a more accurate figure I also need to add the further contributions I'm going to receive by being contracted out of SERPS.

All in all, you can see that these figures are often of  little use when it comes to estimating your pension. Regulations require that certain information is provided, but there almost seems to be more that's missing. On top of this, conservative growth assumptions are used but it would be better to have a range that actually included what's most likely to happen. As usual, there is no substitution for doing the homework yourself. With spreadsheets and calculators now available it's also a lot easier to experiment with different assumptions to see what affect this has on the final outcome. Remember that because you are making estimates about future growth, you'll need to revisit the sums every year to check that you're still on track for receiving the level of retirement income you think you'll need.

More: Pension Centre | Calculators | Part I