Why your pension fund suddenly looks a lot worse

It's the one section of an annual pension statement that people invested in defined-contribution pensions or PRSAs (personal retirement savings accounts) may look at: how much income your retirement savings are going to offer you in retirement.

If you have checked yours of late, however, you may have got bit of a fright. A pension that last year was promising an annual income of €30,000 once you turn 65 or 66 may now be projecting income of only €20,000. That’s a swingeing cut at a time when your ability to work to make up the difference has diminished.

And this is despite the fact that stock markets are rocketing.

Before you panic about where all your savings have gone, they haven’t. What has changed is not how much you’ve saved but the projection about how that will grow over time. But it does make one wonder about the validity of such projections in the first place, if they can be changed so suddenly to give such significantly different outcomes.

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The statement

If you have a pension – other than a defined-benefit scheme which pays a pension as a proportion of your salary based on years of service – then every year you will likely get a “statement of reasonable projection” with your annual statement. This can also be checked online if your pension provider offers such a service.

Someone close to retirement will have little time to change their outcome in retirement, especially if they have been following over-optimistic projections

The statement predicts the likely future value of a pension and is based on assumptions relating to future contributions and investment returns, and the cost of buying an annuity when a member retires.

For example, an expected annual growth rate of 5 per cent meant that if you put €12,000 a year into your pension, after 30 years you would have a fund of almost €800,000. This could then pay out an annual income of up €28,620 based on an annuity rate of 3.585 per cent.

The changes

Now, however, how these projections are calculated has changed.

Earlier this year, the Society of Actuaries in Ireland published a recommendation that pension providers should adopt new standards when giving projections on pensions.

Philip Shier, head of actuarial practice, says the society has a duty to make sure that such projections are "fair, clear and not misleading" and, given the continued trend of low interest rates, felt it was an opportune time to adjust these assumptions.

“We felt that because of very low interest rates, using the existing assumptions were over-optimistic, so we felt we should review it,” he says, adding, “We were particularly conscious that bond and cash returns were a fair bit out of line with the market.”

This is particularly pertinent for pension savers who are coming close to retirement, as one of the big changes has seen the forecast growth on cash fall from 1 per cent per annum to zero. On bonds, the figure has fallen from 2.5 per cent to 1 per cent.

Someone close to retirement will have little time to change their outcome in retirement, especially if they have been following over-optimistic projections which may not now materialise.

Other changes include a reduction in the forecast return of equities from 5 per cent to 4.5 per cent.

In addition, providers previously could apply a growth rate of 2.5 per cent to future earnings. So, for example, if you invested 5 per cent of your salary in your pension, your projected fund would be based on this absolute sum growing by that amount every year. Now however, providers can assume only a pay rise of 1.5 per cent each year.

The expected rate of annuity has also been cut, with an assumption of 1.5 per cent annuity escalation cut to 1 per cent, and an annuity discount rate of 2 per cent cut to 0.5 per cent.

The new approach has been in place since March and applies to all pension providers in Ireland.

Practical impact

The immediate impact of the change is that people’s projected pensions will have fallen substantially.

As Irish Life notes in an update to its customers, "the projections will be more conservative and the estimated pensions shown will therefore be lower than has been shown to date".

As a result, Shier says, "There will be people who look at their statements and wonder why their projected benefit has fallen."

It’s important to note, however, that the projections aren’t related to how much you’ve already paid in, or by how much it may potentially grow, and your actual benefits in retirement.

“This change only affects how we calculate the forecasts,” says Irish Life. But it’s quite a swingeing change to forecasts nonetheless.

Consider the following example from Irish Life. Terry is 60 and contributes €100 a month into his pension, with a retirement date in six years.

At his last pension meeting, he was told that his fund would be worth €8,204 by the time he retires, giving an annual income of €336. However, based on the new assumptions, his new expected income has slumped to €278, a decline of 17.4 per cent.

People are now more likely to opt for an approved retirement fund (ARF) which keeps their pension fund invested

And the younger you are, the bigger the drop in your pension retirement income.

Alex is 40, and contributes €100 a month into his pension, with a planned retirement age of 66. Under the old rules, he was projected to have a fund worth almost €65,000 at retirement, giving an income of €2,495 a year. Under the new rules, however, his income has been slashed by 33.4 per cent, with a projected pension fund of just €49,741, and income of €1,661.

As Irish Life notes, these are just projected figures. However, they are projections to which people will likely attach a lot of value.

Do projections still make sense?

Given the confusion the latest changes might cause, it does make one wonder about the value of such projections in the first place; particularly considering that they are used only for illustrative purposes and are unlikely to play out as proposed.

The problem is that they can make you think if you do x you’ll get y at the end. It’s a key element in advising people on the merits of setting up a pension in the first place, putting real figures on an otherwise nebulous concept. But as anyone who has retired with a defined-contribution scheme or PRSA will tell you, outcomes can be very different.

"The projections are never going to be correct. They're never going to be exactly what the person gets out the other side," says Trevor Booth, head of financial planning advice with Mercer, adding that they should be treated "more like a compass to direct you along where you're going, as opposed to being an absolute value".

Shier agrees and says the the merit of giving a projection still holds.

“The idea of giving projections is to help people to decide if they’re saving enough. To do that, you need to give them some sort of handle on what might happen,” he says. “Its value is to give people a sense of whether the amount they’re saving is sufficient.”

This is the value of projections, experts say. “Most people don’t save enough. At least if they get a projection, and they don’t have enough saved, and they see they’re not on track to save enough, it will give them a wake-up call and encourage them to save more,” says Booth. That’s also why it is important to adjust the assumptions behind such projections when long-term market trends change.

The danger, of course, is that the sharp fall in income projections heralded by the latest cut to assumptions may mean that some people will simply lose confidence altogether in the projections. Shier notes that actuaries would perhaps be happier to give a range of possible outcomes, rather than a specific figure, as this may be a more realistic view.

Projections and annuities

A further issue arises due to the route most people will take in retirement. While the projections are based on how much of an income your fund might buy once you retire, this presumes that people will take out an annuity. With interest rates so low, however, and annuities such poor value, people are now more likely to opt for an approved retirement fund (ARF) which keeps their pension fund invested.

“Most people are choosing the ARF fund. The popularity of annuities has fallen off in the last two /three years,” says Booth, adding this is because, with annuities, people may not now expect to get back their original capital until they’re in their 80s.

“It’s putting people off,” he says.

Given this, the new projections may undercut what your fund may eventually realise. You may not elect for an annuity, and may achieve greater returns, and thus a greater income, with an ARF.

“It’s still useful to show what annual income is from an annuity; it gives a better understanding of an income level rather than a total fund figure,” says Booth.