Double or Nothing? Reality Check?

1993: The Assassin - John Badham 

Continuing on the theme of financial planning assumptions, today the FSA have launched a consultation process on reducing investment assumptions. Taking guidance from PWC, the FSA are reflecting on advice to cut investment assumptions about future returns. Unless there is a form of proper explanation, I fear that many will be more confused and deterred from investing - precisely the opposite objective of the FSA.

Assumptions about investment returns boil down to some fairly basic maths. For example, let's take the "endowment mis-selling scandal". Suppose you need to build a fund of £100,000 over 25 years to repay a mortgage. Whilst there is an element of life assurance (which has a price) and investment charges, tax and commission (all of which gave rise to the mis-selling). How much you are asked (or quoted) to contribute depends upon your initial assumption. Setting aside the costs etc as mentioned, just considering the maths to build a fund of £100,000 over 25 years the following would apply.

A 5% growth rate results in £170.03 a month (total outlay £51,010)

A 7% growth rate results in £126.99 a month (total outlay £38,097)

A 9% growth rate results in £93.87 a month (total outlay £28,161) 

As you can see, for many people attempting to keep costs to a minimal amount, you will appreciate why they were lulled into using assumptions about higher rates of return, particularly when at the time, the longer-term average returns were fairly similar. Sadly returns have not held up to the assumptions in the majority of cases and one might argue that the long-term economic picture has altered to the extent that lower rates of growth should be assumed. Hence the PWC advice to the FSA.

The problem is that the proposed rates of return being suggested for a pension or ISA (which have tax advantages) are being reduced from 5%, 7% and 9% to 2%, 5% and 8%. In other words slashing the projected rates 60%, 28% and 11% respectively. This is primarily because of low interest rates and low inflation, anticipated (assumed) for the long-term. Let's take another example... building a pension fund over 30 years to a size of £1m.

Old Rate 9% = £583.31 a month (outlay £209,991)

New Proposed Rate 8% = £705.40 a month (outlay £253,945 = 20% more)

Old Rate 7% = £850.30 a month (outlay £306,109)

New Proposed Rate 5% = £1,221.46 a month (outlay £439,725 = 43% more)

Old Rate 5% = £1,221.46 a month (outlay £439,725)

New Proposed Rate 2% = £2,032.23 a month (outlay £731,604 = 66% more)

Just reflect on these numbers for a moment. You are a bright person and know that actually we have no way of knowing what the future returns will be in practice. We need to make sensible assumptions, which need to be based on experience of reality. Setting aside the problem that some investments are overpriced and some managers are rather poor, do you believe that the "average" person will interpret these figures as guidance and will simply assume that its better to give up before starting, becoming ever more reliant upon the State. It is an irony that the regulator asks us on the one hand to treat past performance as an unreliable guide to future performance, but then stipulates the rules about projections. In truth it would be more grown up to have a proper conversation about individual and personal expectations, attitude to risk and capacity for loss, but this takes time, something which also needs to be paid for. Something that will be a bridge too far for most UK investors from 2013, when their financial adviser is finally forced to ask for a fee - something that we have always done with our clients, so that they are shown the truth about money.

Oh and by the way, if inflation is 2.5% a year, a £1m fund over 30 years is equivalent to roughly £480,000 today. It is the link to inflation that needs exploring very carefully indeed. The problem with the proposed rates, is primarily not that context is everything, assuming a return of 2% when most savings accounts can provide more, will lead people to draw the conclusion that there is no purpose to investing. We will have reached the point of no return - particularly with inflation higher than 2%. Whilst having a realistic assumption is clearly sensible, without explanation, the FSA risks putting off millions of people from making  provision for their future - which will inevitably be linked with ours.