What impact will the changing environment for retirement planning have on financial planners?

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1 The Financial Professional / lia.ie What impact will the changing environment for retirement planning have on financial planners? Paul Grimes QFA, CFP Chief Executive, FPSB Ireland Ltd Financial planning in practice The practice of financial planning can be simplified into three macro level considerations: 1. An exploration of the trade-off between present day consumption and delayed consumption needing to be accumulated for use in later years (wealth management) 2. Assessment of any and all risks associated with the consumption trade-off described above (risk management), and Diagram 1 Wealth Human Capital Retirement Date Financial Capital 3. Management of the transfer of estate assets inter-generationally (estate planning). The consumption trade-off described above is supported by two forms of capital; Human and Financial. The graph opposite illustrates the conceptual interaction between these two macrolevel forms of capital Age Human Capital is determined by ascribing a present value sum to estimated future earnings; taking into account age, education past and future, current earnings level, future growth in earnings, amongst other things. Financial Capital includes property, cash, shares (public and private), bonds, funds, pensions etc. For most, the single biggest financial asset is the accumulation of pension rights. The trade-off principle works on the basis that at some future point, one 6

2 Volume 3 / Issue 1 / January 2015 needs to have accumulated sufficient financial capital so as to be able to derive one s lifestyle income from financial capital rather than earnings (human capital). This point in time for most is described as retirement. This article explores the heart of this financial trade-off: the accumulation of pension assets, and in particular the consequences for consumers, and by extension financial planners, of the shift away from defined benefit (DB) pension schemes to defined contribution (DC) pension schemes. The shift to defined contribution pension schemes has resulted in an increased risk that consumers will not achieve their retirement objectives... Since the early 2000s the corporate world has been forced to re-assess the way it deals with employees pensions. Declining interest rates and equity valuations, combined with increased life expectancy, resulted in the value of pension liabilities rising while the value of the assets held to meet them fell. New accountancy standards forced companies to take these deficits into account when preparing financial statements with resulting consequences for the financial health of the employing company. In many cases the continued existence of the company is threatened because of their inability to meet their obligations under defined benefit plans. In extreme cases some companies have already gone bankrupt. The result has been acceleration away from defined benefit schemes towards defined contribution schemes, thereby transferring the investment risk from the company to individual employees. Defined contribution schemes have now become the main vehicle for private retirement saving. This shift in risk ownership away from the company and onto the individual may help to reduce the liabilities of the company, but it has also, most likely, increased the likelihood of a major crisis in future years. I have written previously of this risk 1, and specifically how it will be manifested as a consequence of individual consumers now having to make complex investment decisions with little or no financial expertise; with behavioural biases influencing critical decisions, most often to the detriment of the individual investor. One consequence of the shift to defined contribution plans is the changing nature of the retirement conversation with clients. Defined benefit scheme members are used to expressing their retirement position in terms relative to their salary; for example my pension will be 2/3rds of my final salary. Defined contribution scheme members have lost this connection between salary and pension, even though most appear to still think in this way. For defined contribution scheme members investment communication is now focused on asset values, the returns on investment funds, and the volatility of returns. The primary concern of DC scheme members is however no different to DB scheme members. It remains What will my pension be, and will I have sufficient income in retirement to live comfortably?...leading to increased dependency on state resources... Concurrent with the changes in private pensions funding methods, governments of developed economies with welfare state models are under increasing pressure to deal with their respective pensions time-bombs. Changing demographics, including increased life expectancy, improving living standards, a decline in the tax base due to changes in the ratio of income-tax-paying citizens to retired citizens has, and will continue to, inform government policy in the areas of taxation, retirement and social welfare. For example, in Ireland recent policy changes increased the retirement age for State pension purposes to 68 from 65 for those born after Jan 1st It is very possible that future policy changes will further reduce access to the State pension, at a time when developments in the funding of private pensions are likely to result in the increased likelihood of consumers not attaining their retirement planning objectives by means of private funding. So in addition to having to make complex investment decisions relating to their private pension arrangements, consumers are faced with the additional risk that the safety net of welfare will in future years be curtailed....and the need for specialised financial planning advice in the pre- and post-retirement years.. For most, these developments and the related complexity of managing the accumulation of financial capital to meet post-retirement lifestyle needs are little understood. For example, for those that are now members of a defined contribution scheme, the most basic of questions to be considered is how much financial capital is needed to provide a retirement income. And the answer is it depends. Basic factors that will inform and influence this calculation are: 1 Behaviour and Financial Planning published in The Professional in October

3 The Financial Professional / lia.ie What is the preferred retirement age? Will the State pension be available? What annuity rate (the rate used to convert pension capital into pension income) to use? For example, take a 40-year-old employee who is a member of a DC scheme, who would like to retire at age 65 on an income of 40,000 gross in today s value. The capital sum needed to provide this income at retirement, using different annuity (pension) rates is set out in Table 1. For a 65 year old retiring today, annuity rates are circa 3.37%. As annuity rates will fluctuate with economic cycles, Table 1 gives an idea of the sum of capital required under different annuity rates, starting with today s rate. The next question is, how much does one need to contribute to a defined contribution pension plan in order to provide the capital necessary to deliver the required retirement income? And the answer again is it depends. If we continue with the example of the 40 year old wanting to retire at age 65, with a requirement for capital at retirement of 1.7 million (from Table 1 it is the scenario assuming annuity rates of 4% with full state pension available from age 68), Table 2 illustrates the monthly rate of saving required in order to accumulate this sum of capital using different rates Table 1 of investment returns. So clearly, the asset allocation decision, i.e. what type of assets to hold within the pension structure, is a key consideration. The higher the rate of return secured on investment, the greater the proportion of one s financial capital that is derived from investment markets, thereby reducing the level of savings required to be diverted from current consumption towards future needs (in itself another trade-off to be considered). Consumers that make it to retirement with satisfactory pension funds (DC) will then be faced with decisions as to how best to convert this capital sum into income. For many, the choice will be between an annuity-based income; or a self-managed sinking fund in the form of an Approved Retirement Fund and Approved Minimum Retirement Fund. For further reading on this particular dilemma I refer you to a fine article written by Tony Gilhawley and featured in the April 2014 edition of The Financial Professional....involving increased risk analysis and alternative reporting and communication approaches with clients. This example has, at a macro level, illustrated that the determination of the capital amount required to fund post-retirement lifestyle can be a moveable feast, as can the associated calculation to determine how much needs to be set aside monthly to accumulate the targeted capital amount. At a micro level, these calculations require ongoing consideration and management: Annuity Rates 3.37% 3.75% 4.00% 4.50% 5.00% If State Pension is available If State Pension is not available 1,990,890 1,814,607 1,716,897 1,554,048 1,423,768 2,481,514 2,233,363 2,093,777 1,861,136 1,675,022 Assumes inflation at 3% and that State pension is payable from age 68 Assumes no pension planning in place N.B. Standard Fund Threshold would need to be considered in determining the amount to be accumulated within a pension structure. Table 2 Monthly contribution required (flat) Monthly contribution required (indexed) Investment returns 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 3,840 3,328 2,871 2,465 2,107 1,793 2,733 2,416 2,130 1,873 1,644 1,438 Indexation assumes that the monthly contributions are increased by 3% annually Tax relief has not been factored into these calculations 8

4 Volume 3 / Issue 1 / January Future changes in government policy Will the State pension continue in its current format into the future? Given the twin problems of increased life expectancy and declining ratio of taxpaying citizens to retirees you would imagine that the current situation will have to change, most likely resulting in decreased benefits. The pension time-bomb has been well flagged. Policy initiatives are likely to result in some form of mandatory pension contributions from all citizens, possibly to a state-sponsored scheme (other than PRSI). The current pension regime operates on a taxdeferral basis. Given the state of public finances, is there any possibility, albeit remote, that as part of an overhaul of the private pension system consideration might be given to replacing tax relief on contributions with some form of relief when accessing pension income? Government levies imposed on private pension schemes reduce the amount of capital available to provide retirement income. A levy of 0.6% sounds immaterial, but if you refer back to Table 2 and the difference that a 1% increase/decrease in investment returns has on the required savings rate you will quickly realise that these levies do have a material impact. Adjustments in levy rates will have a correspondingly negative/positive impact on the savings level required to deliver retirement income needs. There is every possibility that future policy developments will provide retirees with a greater range of income options at the point of retirement. Each of these options will likely bring its own level of risk and further increase personal responsibility for the determination of retirement lifestyle. 2. Other environmental factors: Future annuity rates will be influenced by future bond yields. Planning needs to take account of changes in bond markets. During the accumulation years, the rate of return earned on the invested funds is critical. Careful management of these assets from an investment perspective is needed, as any shortfall in targeted rates of return will result in a shortfall in retirement assets. Presently, there are revenue limits as to how much an employee can accumulate in a pension fund before punitive tax rates apply. This requires careful management on the part of employees and their financial planners. There are costs associated with running pension schemes that will erode some of the investment returns within the scheme. Management of these costs can have a material impact on the final amount of capital accumulated within the pension structure. (Refer back to Table 2 to get a sense of the impact that charges, in the form of reduced investment returns, can have on funds). Finally, if we recognise that consumers think of retirement in income rather than capital terms, logic would suggest that reporting should reflect this. Regular reports on the value of funds and annual performance data do not inform the client as to their likely standard of living in retirement, in income terms. Behavioural finance research suggests that client education in investment management is not necessarily the best solution to this problem. Improved consumer education can have unintended adverse effects, as it has been found that individual investors repeatedly make poor financial investment decisions to their financial detriment. Somewhat controversially, there is an argument that reporting and communication in this area should be limited to the probability of the consumer achieving their retirement-income lifestyle; and that this dialogue should continue into the post-retirement years. The role of the financial planner in assessing fund manager performance becomes more important under this scenario. In conclusion There are three factors that make this topic particularly relevant to financial planners and consumers. First, the move away from defined benefit to defined contribution retirement schemes, requiring individuals to accept increased responsibility for the accumulation of personal retirement assets. Second, changing demographics will likely force further changes to government policy which will further restrict the availability of state pension. Third, an increase in responsibility also means an increase in risks that require careful management throughout both the wealth accumulation and post-retirement years. Financial planners have the opportunity to assist consumers with this complex area of financial management. This should present opportunities for new models of engagement, alternative reporting and communication styles, and new revenue models. For product providers, there is an opportunity to develop new product streams to provide consumers with the mechanism to save for an income stream. This article has focused on the move from DB to DC schemes. The arguments presented are equally cogent for consumers with Personal Pension plans. 9

5 You are invited to a free breakfast briefing hosted by LIA, The Institute of Banking and The Irish Tax Institute: Financial Planning: Crisis and Opportunity for Practitioners. The emerging retirement planning crisis presents both risks and opportunities for financial planners. The current crisis in retirement planning provisioning requires financial advisors to develop new skills and perspectives on the management of clients assets. This briefing will explore emerging changes to practice standards and processes. It will also consider at a macro level, the challenges involved in adapting new skills, practice standards and business models. Date: Thursday, August 20th 2015 Time: 8am 9am (registration from 7:45am) Cost: Free Venue: The Institute of Banking, IFSC, 1 North Wall Quay, Dublin 1. CPD Hours: This event is accredited for 1 CPD hour for QFAs*, CPD Members* (including Registered Stockbrokers), LCOIs and Chartered Bankers. Presenter: Paul Grimes, CEO, Financial Planning Standards Board Paul Grimes, Certified Financial Planner professional, CEO of Financial Planning Standards Board Ireland Ltd, and Graduate Diploma in Financial Planning programme lecturer will discuss his own experiences and share developments in the Financial Planning industry in Ireland and overseas. This breakfast briefing will give you the opportunity to sample a typical postgraduate lecture. It will also allow you to network with fellow financial services professionals and meet with staff who will be happy to answer questions you may have on the Graduate Diploma in Financial Planning. * Relevant to categories of retail financial products: 2) Pensions, 3) Savings and Investments

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