A Guide to Pension Illustrations

A crucial tool in the retirement planning process is a pension illustration, which may be used to show the potential benefits from the existing fund and can include additional funds from transfers and contributions. 

More than just a simple number, these illustrations offer a projection to the member’s selected retirement age, showing them their potential retirement income, empowering them to make informed decisions about their financial future based on the guidance given.

This article will cover the following:

• What is a Pension Illustration?
• Why are They Important?
• How are Pension Illustrations Calculated?
• What Should a Pension Illustration Include?
• Understanding the Nuances
• Making the Most of the Pension Illustration

What is a Pension Illustration?

A pension illustration is a projection of what a member’s pension pot might be worth when they retire, and the income it could provide. It's an estimate, not a guarantee, but it serves as an invaluable guide for understanding whether a member's current savings trajectory aligns with their retirement aspirations. 

A member will typically receive a pension illustration as part of their annual pension statement.

Illustrations may also be issued when amendments to the plan are considered, from adding new money to the plan.

Why are They Important?

Pension illustrations are vital for several reasons:

• Financial Planning: They help you assess if a member is on track to achieve their desired retirement income. If the projection falls short, it's a clear signal to consider increasing contributions or adjusting the member's investment strategy.
• Transparency: Regulations ensure a degree of consistency in how providers present these projections, allowing for some comparison between different pension products.
• Informed Decisions: By understanding the potential outcomes, you can make more educated choices about the guidance given to the members regarding their pension, from the level of risk they are comfortable with to when they might realistically retire.
• Awareness of Charges: Illustrations often detail the impact of charges on their fund's growth, highlighting how even small percentages can significantly affect their long-term returns.

How are Pension Illustrations Calculated?

The calculation of a pension illustration is a complex process, governed by stringent regulation. Guidance on the key components can be found in the Financial Conduct Authority (FCA) Code of Business Sourcebook (COBS). Details can be seen in the links below.

• COBS 13.4 Contents of a key features illustration - FCA Handbook
• COBS 13 Annex 2 Projections - FCA Handbook

Key factors and assumptions in these calculations include:

• Contributions: Both a member's regular payments and any employer contributions are factored in, as well as ad hoc payments for planning purposes.
• Investment Growth Rates: Providers use a range of projected growth rates (typically low, mid, and high) to demonstrate different scenarios. These rates are based on the risk profile and historical volatility of the underlying investments. Our illustrations use 3%, 5% and 7% growth rates.
• Inflation: A crucial element is the adjustment for inflation (currently often assumed around 2% per year in UK illustrations). This shows the "buying power" of the projected pension in today's money, giving a more realistic picture of what that income will be able to purchase in the future.
• Charges: All applicable charges (annual management fees, fund charges, etc.) are deducted from the projected growth; this may include adviser fees as well.
• Retirement Age: The illustration will be based on a stated retirement age (often 65, unless you specify otherwise).
• Annuity Rates (Historically): Historically, illustrations often assumed a member would use their pension pot to buy an annuity (a guaranteed income for life). While this is still an option, many illustrations now reflect other ways of taking benefits, such as drawdown, although the annuity assumption is still frequently used for the projected income figures due to regulatory requirements.
• Other Assumptions: Illustrations may also make assumptions about tax-free cash lump sums (often assuming none is taken for the projected income figure), whether the pension is for a single life, and whether it includes a guarantee period.

What Should a Pension Illustration Include?

A comprehensive pension illustration should typically provide:

• Projected Fund Value at Retirement: This shows the estimated value of the scheme at the chosen retirement age for the illustration.
• Projected Annual Income: An estimate of the annual income the member may receive from that fund, often presented in "today's money" to account for inflation.
• Different Growth Scenarios: Projections based on low, mid, and high investment growth rates to demonstrate the range of possible outcomes.
• Detailed Charges Information: A clear breakdown of all fees and their impact on the pension's growth.
• Summary of Assumptions: A list of the key assumptions used in the calculations, such as the inflation rate, investment growth rates, and retirement age.
• Important Warnings: Disclaimers stating that the figures are not guaranteed and that investment values can go down as well as up.

Understanding the Nuances

While pension illustrations are invaluable, it's important to approach them with a critical eye:

• Estimates, Not Guarantees: Future investment performance, inflation, and annuity rates are all subject to change. The illustrations are based on current assumptions and past performance, neither of which guarantees future results.
• Inflation's Impact: The "today's money" figures are crucial. They help you understand the real purchasing power of your future pension, as inflation erodes the value of money over time.
• Different Providers, Different Assumptions (though becoming more standardised): While regulations aim for consistency, there can still be slight variations in the underlying assumptions used by different providers. It's always beneficial to review illustrations from all your pension schemes.
• Personal Circumstances: The illustration is based on the information the provider holds. If a member's circumstances change (e.g., they increase contributions, change jobs, or their health status alters), the actual outcome may differ.

Making the Most of the Pension Illustration

To effectively use a pension illustration:

1. Review it Annually: Don't just glance at it. Take the time to understand the figures and the assumptions.
2. Compare to the Member’s Goals: Does the projected income align with the lifestyle they envision in retirement?
3. Consider Increasing Contributions: If they are off track, even small increases to their contributions now can make a significant difference over the long term due to the power of compounding.
4. Understand their Investments: Familiarise the member with the funds the pension is invested in and their associated risks and charges.

Pension illustrations are a vital compass for navigating the journey to retirement. By understanding their components, limitations, and implications, members can take control of their financial future and work towards the retirement they desire.