The trouble with pension projections

How much can defined contribution pension savers expect to derive at retirement from their current pension pot? This turns out to be a remarkably tricky question to answer — and one where the rules are about to be rewritten.

As a result of proposed changes, millions of people in the UK may find that from October 2023 onwards their pension statements show markedly different projections to previous statements, especially for those many years away from retirement.

Since the start of automatic enrolment into workplace pensions in 2012, more than 10mn people have started saving for their retirement for the first time.

Overwhelmingly, they have been enrolled into a defined contribution (DC) pension — an investment product designed to give them a pot of money to support themselves in retirement. Many millions more already held DC savings via personal pensions or stakeholder pensions or similar vehicles.

As a pension saver you might reasonably assume that pension companies and pension schemes are subject to strict rules about how they project your current pension pot into an estimated income in retirement. But those rules, currently under the auspices of the Financial Reporting Council (FRC), allow pension providers a remarkable degree of latitude as to how they go about pension projections.

In particular, providers can and do vary considerably in the rate of return they assume that members can expect for different types of investment.

These differences are shown starkly in a chart published by the FRC in 2020. This is based on anonymised responses from 17 insurance companies, wealth managers and consultancies who between them issue well over 20mn pension statements a year.

The top line shows the rate of return assumed on investment in equities, with growth rates ranging from around 4 to 7 per cent. Assumed rates of return on corporate bonds vary from 1 to 4 per cent, on gilts from under 0.5 per cent to around 4 per cent, and on cash from around 0.5 to 1.5 per cent.

Even over one year these would result in significant differences, but the compounded effect of this variation in assumptions could have a huge effect on the size of a projected pension pot.

To give a simple example, consider a pension pot of £50,000 held by someone who is 20 years away from retirement and invested wholly in equities. If the provider assumes growth of 4 per cent per year this would generate a forecast pot of just under £110,000. But at 7 per cent annual growth, the pot would be projected to be worth just over £193,000, around three-quarters larger for the same current pension pot.

Variations like this are worrying enough as it is, but with the advent of the proposed pensions “dashboard”, the case for change becomes overwhelming. On the dashboard, savers will be able to see all of their pensions in one place. Without reform, they will see different pensions projected in wholly different and inconsistent ways and struggle to make sense of the numbers.

In response, the FRC this week concluded a consultation in which it proposes standardisation of investment growth assumptions. These changes, if implemented, would apply to all statements issued after October 2023, regardless of progress by that point on the pensions dashboards project.

On the face of it, the FRC’s desire for standardisation is entirely sensible. It is going to be hard enough for savers to understand the information they see on a pensions dashboard without having huge inconsistencies in the underlying investment return assumptions between different pension providers.

However, the way in which the FRC plans to implement these changes raises serious concerns. In order to standardise growth assumptions, one obvious approach would be to specify for each major asset class the rate of return which providers are to use. These assumptions could be kept under regular review as market conditions change.

Unfortunately, the FRC has not gone down this route.

Instead, it proposes to model future investment growth on the basis of the volatility of returns in the recent past. Based on the principle that higher- risk investments tend to be associated with higher rates of return, the FRC argues that if an investment fund has been volatile in value in recent years it is probably a high-risk fund and therefore can be assumed to generate high rates of return in the future.

Conversely, an investment fund which has been relatively stable in value in recent years would be deemed “low risk” and hence “low return” when it comes to projecting future returns.

While there is a certain logic to this approach, it could produce some perverse results. Had it been in force five years ago, for instance, a fair number of equity fund values would have been found to be relatively stable while some government bond returns would have been relatively volatile.

Applying the FRC’s logic, this could mean that where a saver was invested heavily in equities the provider may have to project a low rate of growth; where the saver was invested heavily in bonds, the provider may have to assume a high rate of growth. This is the exact opposite of the approach currently taken (as shown in the chart) and also the opposite of what we would expect to see in practice.

Any switch to a new basis for pension statements is likely to create upheaval and will prompt many questions from savers who may suddenly see big changes on their pension statements. For some savers it could be even more dramatic if it coincided with a big move in the current value of their investments during a period of market turmoil.

If standardisation is to come it should be on a relatively simple basis which savers will be able to understand. There is a real risk that if the FRC’s proposed approach is adopted, the new statement figures will make little more sense than the old ones.

Sir Steve Webb and David Everett, who contributed to this article, are partners at consultancy LCP.