SMPI - Statutory Money Purchase Illustrations
Under the existing pension rules we’ve been used to for the last fifty years or so, the millions of people saving for a pension in the UK have basically been in one of two types of pension; either a ‘Final-Salary’ company pension scheme; or a ‘Money-Purchase’ pension arrangement which could be a company pension scheme or it could even be an individual pension arrangement, such as a Personal Pension. For years and years we referred to these two different types of pensions as ‘Final-Salary’ and ‘Money-Purchase’, that is until we became American quite recently and started referring to them respectively as ‘Defined Benefit’ and ‘Defined-Contribution’ pensions instead.
Those of us who are thoroughly modern don’t even bother referring to these by their full names any more; we just call them DB and DC. It’s a priesthood thing. It prevents the common people ever understanding a word we say. Keeps them in their place.
Anyway, the essential difference between the two basic types of pension, whatever we call them, is that the final-salary company pension scheme provides a defined benefit promise to employees from an employer which the money-purchase scheme does not. Rather, the money-purchase approach to pensions means that people, often with the help of their employers (but sometimes on their own), simply build-up a fund of money that is to be used to purchase an annuity at the end of the saving period. (An ‘annuity’ is the name industry-insiders use instead of the everyday word ‘pension’ that 99.99% of the population use and understand. It’s another priesthood thing.) So, and in a nutshell, people in some schemes know pretty well what amount of pensions they’re going to get when they retire because their employers promise them a pension of a set percentage of their final earnings. But many other people don’t know what their pension will be, because essentially all they’re really doing is building up a pile of money to buy a pension with in the dim and distant future.
Naturally, though, people need some idea of what pension they’re likely to get when they retire, if for no other reason than to plan the rest of their lives. And that’s where the annual benefit statement comes in. Once a year people in pension schemes get a sheet of paper from whoever runs the schemes for them, usually their employer or a pension provider, and these are cleverly designed to give some idea of the pension they can expect to get in years to come. For defined-contribution or money-purchase pensions it’s all guesswork though. Nobody really knows exactly what the future holds, so no-one can say for sure exactly how much money anyone would need to buy a particular amount of pension way in the future.
There are obviously a number of variables involved that take any calculations into the realms of the fairly to very fiddly. First off, the effect of inflation over a long period of time is not only impossible to predict in advance, but it is also an enormously difficult thing for people to appreciate; it’s kind of counter intuitive. It can give you a hell of a headache just thinking about it.
For example, I’ve just bought a new car and it’s a Mini. They’re made by BMW now, but are still cute just like the original Minis that were made in the 1960s. In fact, in 1965 when my Uncle bought a Mini Cooper it cost him about £600, which was a fortune then. I’m not exactly sure what National Average Earnings were in 1965 (I could look it up if I could be bothered) but I think it was somewhere around £1,100 a year. So £600 must have been a fair percentage of National Average Earnings in those days. The Mini I’ve just bought also cost a fair percentage of National Average Earnings as they are today. I paid a little over £15,000 for it and National Average Earnings are at around the £25,000 mark. In fact, the current Mini is possibly relatively cheap compared to what my Uncle’s cost back then (I’ve had loads of boy-racer type extras put on my Mini, but I think the basic model is just a bit over £10,000).
The thing is, if someone had set out in 1965 to save up to buy a new Mini in 2003, nearly a forty-year saving period, how would they have gone about it? It would have seemed amazing to my Uncle in 1965 to be told he’d need to save up something like £15,000 to buy a new Mini in 2003, particularly as he was probably only earning around £800 a year at that time. The three bedroom semi-detached house he’d just bought in those days had meant he’d had to take out a mortgage of £2,500 and he regarded that as a bit of a millstone around his neck as it was. If you’d told him he would need to put nearly six times as much aside to buy a Mini he would have thought you were a nutter.
The trouble is, we put the same pound sign in front of numbers to denote value today as we do in front of numbers that are meant to denote value in the future. We should use a different symbol, but we don’t. And that’s where the confusion comes in. A ‘pound’ in 1965 had a completely different and much higher ‘value’ than a ‘pound’ does now. But we have it caught up in our heads somewhere that they are both ‘pounds’. It's almost as if we seem able to accept that we know rationally that they can’t be the same, but a part of us still seems to think they are anyway. If you don’t believe we all think in this weird and irrational way, just think back to your own private thoughts that ran through your head when you read in the last paragraph that my Uncle only paid £2,500 for his house. I’ll bet you thought something like, “Wow, that was cheap”, or “I wish houses still only cost that sort of amount now”, or something similarly silly. Most people think that way. You, me, all of us. It’s a hard habit to kick. I notice I’ve even referred to it as ‘only’ £2,500 in the last sentence or so. It’s so intricately and subtly caught up in the way we use language. No wonder we find it so hard to think sensibly about things like this.
Pension saving is a forty-year hike, just like the hypothetical forty-year savings plan to buy a Mini that I’ve just used to illustrate a point. Forty years is a long time. How many ‘pounds’ should people save now to produce a pension of a certain number of ‘pounds’ in years to come? What do we think those two ‘pounds’ are in any case? Do we think they are the same? Even if not, do we really understand how very different they probably are? And, hell, how do we even think we’re going to be able to explain it to anybody else anyway? Perhaps too many pre-conceptions are already in the way. Perhaps our language isn’t up to the job. Perhaps we don’t really understand it ourselves. Just because we’re in the priesthood, it doesn’t mean we’re infallible or anything.
The SMPI basis for defined-contribution pension illustrations that is just about to come in is designed to provide a sensible look at the real level of pension people can expect in the future given the level of money they are currently putting aside. SMPI stands for Statutory Money-Purchase Illustrations, by the way, and confusingly uses the (pre-American) term ‘Money-Purchase’ for the more up-to-date and infinitely more cool ‘Defined-Contribution’. Another difficult bend that those who only have a rudimentary grasp of pensions jargon could lose it on.
But, it doesn’t matter what we call things as long as we all understand what is really going on. The application of the new SMPI basis for projections will mean people should get a much better idea of the amount of pension they are heading for. It’s still a guess, though, because that’s all it ever can be, or ever could have been. Just like the basis it is replacing.
The variable value of money we have spoken about in this simplistic look at saving for a Mini over a long period of time is hard to get the hang of. With pension savings, though, there’s a lot more to it than just the change in the value of the ‘pound’ over time. The ‘cost’ of buying a ‘pound’ of pension also appears to be increasing. This is because it looks like, on average, we will all live longer than we previously thought we would. That’s great news, of course, but if we do and want to spend those extra years in retirement, rather than working, then we will need more savings to live on. That simple fact translates into an ‘increase’ in the ‘cost’ of a ‘pound’ of pension. There are loads of tricky concepts tied up in that last sentence, all compounded by the fact we seem to be hard-wired not to understand the effects of inflation anyway. And while we’re on about inflation, who really understands that choosing a ‘level’ pension when you retire means you are actually choosing a pension that will decrease in value every year you live on in retirement? This will all need a good deal of careful explaining when people begin to get their new-style illustrations soon, and that is part of the much-misunderstood value many put on ‘financial advice’ itself. It’s not just as simple as explaining to clients that stock markets can go down as well as up, as some would have us all believe. Like most things, there’s a bit more to it than newspaper headlines can properly convey.
What we all need to be wary of, I think, is a kind of reverse reaction to the one that makes us think £2,500 in 1965 was cheap for a house. The reaction to an illustration of pension benefits that goes along the lines of “Is that all?” or “I thought I’d get a lot more than that!”, is an understandable one if people don’t first realise that the pound signs in front of the numbers meant quite different things in the past than they do now, or they will in the future. To understand them properly we need to understand what we’re looking at first. That’s got a lot to do with the value of advice in my book, and people being properly advised on their pension saving are much more likely to understand this stuff than people who buy so-called cheaper pensions off the shelf. But that’s another story.....
3 April 2003
The information provided is based on Scottish Life’s current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice.