How Much Pension Provision Do You Already Have?
The first step in retirement planning is to ascertain what your financial needs will be at and after retirement. You and your adviser should next proceed to find out how much pension provision you already have. This is important because part or occasionally all of your pension needs would have been already provided for, and you wouldn't want to start saving up for something that already exists; would you? Existing pension provision will fundamentally comprise Basic State Pension and possibly some additional earnings related pensions (top-ups) as well as some Occupational or Individual pensions. We will consider these in greater depth in the sections that follow.
It is not very straight forward attempting to working out how much state pension you will be entitled to at retirement; only an estimate can be established. Anyone who is more than four months and four days old from state retirement age can fill an application form (BR19) and send it off to Department of Works and Pensions (DWP) for a forecast of state pension entitlement.
A State Pension Forecast letter that will be received from the Pension Service of DWP will have a breakdown of how much state pension you can expect in terms of Basic State Pension, Graduated Retirement Benefit, State Earnings Related Pension (SERPS) and State Second Pension (S2P). There will be figures representing the amount of state pension you have earned to date, how much more you might earn between the date of issue and retirement and how much basic state pension you can expect to earn at retirement. The forecast also goes on to suggest possible ways through which the basic state pension can be possibly improved.
The basic state pension forecast is expressed in today's money terms and it does make sense; why? When considering your financial needs at and after retirement, common practice is to express it in terms of a proportion of pre-retirement earnings, which is in today's terms. Since inflation does erode the purchasing power of money, it does make a lot of sense to find out what your pension projections for the future will be (considering inflation) in relation to that proportion of your current earnings (in today's terms). For example the retail price index (RPI) in the UK in October 1983 was 86.7 and 182.6 in October 2003. This means that £1 in 2003 will be needed to buy what 47.5p could buy in 1983.
The forecast will say how many units of Graduated Retirement Pension has been attained and what this is worth. As regards S2P and SERPS it will mention what has been earned to date, what might be earned between the date of issue and retirement, as well as what can be expected at retirement. If there has been any contracting out, the forecast should make mention of what deductions in S2P and SERP it leads to. A widow or divorced person will also get to know possible state pension entitlement that might ensue from the national insurance contributions of the former or late spouse.
If you are an existing member of a final salary scheme, you can find out what pension benefit you have earned in two ways: through the scheme booklet or the annual benefit statement. The scheme booklet will provide you and your adviser information about what the accrual rate of the scheme is (say 1/60th or 1/80th) and also give you an idea of benefits that will be paid on death before or after retirement. With such information you will be able to work out what proportion of your pre-retirement earnings will paid as pension. Benefits in a final salary scheme of a previous employer will be 'preserved' and revalued annually to the set retirement date. You can also request this benefit to be transferred to a new employer, with a value technically called the 'cash equivalent transfer value'. This is the value of the benefit revalued to the date of normal retirement stated in today's terms. These bits of information put together will enable your financial adviser to find out the value of the final salary scheme benefits at retirement and in today's terms. The annual benefit statement will mention the level of benefit earned to date and your total contributions.
Indeed, the pension provision can also exist in a 'Money Purchase' scheme which can be an Individual pension scheme, such as a Personal Pension Plan, or an employer sponsored arrangement. Apart from Retirement Annuity Contracts, all members of 'Money Purchase' schemes are entitled to receive annual illustrations known as 'Statutory Money Purchase Illustrations (SMPIs). This illustration does provide an idea of what future benefits can be possibly amassed in the scheme. It provides a pension projection giving regard to the effects of inflation.
The benefit figure is reached by first finding out what benefits have been earned to date, adding future contributions (bearing tax-relief in mind), adding any contracting out rebates, and then subtracting charges and expenses of the scheme membership, as well as expenses relating to risk policies, such as pension term assurance. A growth rate of 7% is assumed for the illustration, although in order to avoid over-estimation of returns on investment, a figure less than 7% can be acceptable. The value obtained is then expressed in today's terms, by using an inflation rate of 2.5%. Finally the fund is translated into pension income by the assumption of an annuity rate. The annuity rate is revalued annually in line with RPI. A monetary value can also be put on preserved benefits to be transferred. It is also possible for your financial adviser to request for projections of benefits in future terms, using different growth rates.
Having established your financial needs at and after retirement, as well as how much pension provision there is, the difference between the two constitutes the shortfall (gap), for which a plan has to be put into place to bridge. This will be at a cost which like the other figures should be considered in today's terms. Factors to consider will be inflation, your attitude to investment risk and the charges of the pension contract that will be opted for. Affordability is a big issue, and should be looked at in the light what your present and future expenditure commitments will be; your other financial priorities such as family protection, mortgage payments, funding children's school fees or going on holiday. You should also consider any anticipated changes in your financial circumstances.
Other financial needs will always exist alongside those of retirement. In fact one's financial needs can be endless, but the bad news is that financial resources are normally very limited. You will hence be duplicating your efforts if you have to put your scare resources away for what you have already toiled for. Hence the reason why you need to get the figures right as regards what pension provision is already existent and the amount of shortfall that has to be made up. Also remember that pension arrangements are not the only ways of providing for retirement, and the benefits of other investments as options should be compared. The tax advantages of pension schemes should be pondered on, vis-a-vis the added flexibility that other investment options have.
I have a BA Hons. degree in Accounting and Finance. I am currently specialising in Financial planning.