Understanding Critical Yields

A critical yield is the minimum annual rate of return a member's pension fund needs to achieve to deliver a specific, pre-determined income or lump sum at a future date. It's essentially a reverse calculation. Instead of projecting what they might get based on an assumed growth rate, it tells you what growth rate is required to hit a particular financial goal.

To highlight what a critical yield (CY) is in simplified terms, here’s an example.

1. John has a Defined Benefit Pension Scheme with the NHS.
2. He has had a letter telling him he will receive an annual income of £20,000 per year starting on his 65th birthday, which is in 5 years’ time.
3. His pension will continue on his death for the balance of 5 years from commencement and then 50% to his spouse.
4. The income will rise each year in line with RPI.

1. John requests a Cash Equivalent Transfer Value (CETV), which confirms a value of £350,000.
2. Using simple figures, we assume the scheme pension rises by 2.5% per annum over the next 5 years and therefore would rise to £22,628.
3. If the CETV is transferred to a Personal Pension and a 3% (£10,500) fee is applied, then the value of the Personal Pension would be £339,500.
4. If the value of the fund then grows by 7% per year over the next 5 years, but charges reduce this by 1.5% per annum to 5.5% then in 5 years’ time the Personal Pension would be valued at £443,713.
5. If annuity rates for a 65-year-old male, with a 50% spouse’s pension, provide an annuity rate of 2.8% then the personal pension valued at £443,713 would provide an income of £12,424 (i.e., £443,713 x 2.8%).
6. This is well below the guaranteed income being provided by the current Defined Benefit Pension Scheme.

Where CY comes in is calculating the rate of growth required to match John’s projected DB pension scheme income of £22,628 per annum.

For this to be advantageous, the personal pension value must equal £22,628 ÷ 2.8% = £808,143 in 5 years.  Therefore, the Personal Pension plan would need to grow at 18.9% after charges, giving a CY of 20.4% per annum.

Critical yields are particularly valuable when considering:

• Defined Contribution (DC) Pensions: Unlike Defined Benefit (DB) schemes, which promise a set income, DC pensions depend entirely on investment performance. Critical yields help benchmark the required performance.
• Targeting a Specific Income: If the member has a clear idea of the retirement income they desire, a critical yield calculation can immediately show the investment challenge ahead.
• Comparing Investment Strategies: Different investment portfolios have different risk/return profiles. Calculating critical yields for various scenarios can help you assess if a particular strategy is likely to meet your clients’ goals.
• Assessing Early Retirement: If your client wants to retire sooner than originally planned a critical yield calculation will reveal the significantly higher growth rate needed to achieve their target income over a shorter accumulation period.

Pension illustrations, often provided by pension providers, are projections designed to give you an idea of the potential value of your pension fund at retirement and the income it might provide. These illustrations typically present a range of scenarios, often based on different assumed growth rates (e.g., low, medium, and high).

Critical Yield A: This represents the rate of investment return required on a drawdown pension fund to break even with a comparable guaranteed annuity. In other words, it's the growth rate needed so that the fund can provide an income equal to what could have been secured by purchasing an annuity at the outset and still have enough remaining to purchase the same level of annuity income at a future point (often age 75). It essentially answers the question: "How much does my drawdown fund need to grow to be as good as buying an annuity today?"

Critical Yield B: This shows the average annual return required to ensure that a member will have sufficient pension fund to provide an income comparable to what they are currently withdrawing when they come to purchase an annuity at a future date. This is relevant when a specific level of income is being taken from the drawdown fund, and it addresses the question: "What growth rate do I need to maintain my current income level and still be able to buy an equivalent annuity later?"

• Benchmark: Critical Yield A benchmarks against the income available from a guaranteed annuity purchased at the start. Critical Yield B benchmarks against the income currently being taken from the drawdown fund.
• Purpose: Critical Yield A helps assess whether choosing drawdown is financially comparable to purchasing an annuity from the outset. Critical Yield B helps assess the sustainability of a chosen income level within drawdown, with a view to future annuitisation.
• Focus: Critical Yield A focuses on matching the annuity equivalent income. Critical Yield B focuses on maintaining a specific income withdrawal and then being able to buy an equivalent annuity

While distinct, critical yields and pension illustrations are complementary tools in effective retirement planning:

• Validation of Illustrations: You can use a critical yield calculation to "stress test" the assumptions in a pension illustration. If an illustration shows a comfortable retirement income based on a 5% growth rate, but your own critical yield calculation for that income shows you need 7%, it highlights a potential shortfall or an optimistic projection in the illustration.
• Setting Realistic Expectations: Critical yields help to ground the potentially optimistic projections of some illustrations. If the critical yield required for the member's desired income is an unrealistic 15% per year, it immediately tells you that the current plans set for the member is off track and adjustments are needed.
• Empowering the Individual: By understanding both, members move from passively receiving projections to actively engaging with their retirement planning as long as the content is explained. The member can ask pointed questions like, "What critical yield is assumed for this 'medium growth' scenario?" or "If I want £X income, what's the critical yield I need to hit?"

It's vital to remember that both critical yields and pension illustrations are projections, not guarantees. They are based on assumptions that may not materialise.

Key limitations include:

• Investment Volatility: Markets are unpredictable. Actual returns can fluctuate significantly from year to year, differing from the smooth growth assumed in calculations.
• Inflation: The purchasing power of money erodes over time. A seemingly large pension fund today might not buy as much in 20 or 30 years. Illustrations often factor in inflation, but it's crucial to understand how.
• Charges and Fees: High charges can significantly erode returns. Ensure illustrations are net of all fees.
• Longevity Risk: People are living longer. A pension fund needs to last longer, which impacts the income it can sustain.
• Changes in Legislation: Pension rules and tax laws can change, impacting future benefits.

Critical yields and pension illustrations are indispensable tools for anyone navigating the complexities of retirement planning.

Critical yields provide a powerful benchmark for required investment performance, while pension illustrations offer a visual roadmap of potential futures. By understanding how to interpret and interact with both, individuals can gain greater clarity, set realistic expectations, and take proactive steps to secure their financial well-being in retirement. It's not just about seeing the numbers; it's about understanding what those numbers demand and what actions you need to take today for a comfortable tomorrow.