A CET What?

Anybody who has looked into a defined benefit (DB) pension transfer, would have come across this acronym. A Cash Equivalent Transfer Value (CETV). All well and fine to know what the CETV is, but wouldn’t it be nice to know how it is calculated so that you can have a better understanding on it.

In a DB scheme, the member has safeguarded rights in that they will be given a pension income from pension age until they die; indexed by either RPI, CPI or NAE, as stipulated in the scheme rules.

At any one point in time, these benefits have a cash equivalent value which the member can chose to transfer out of the scheme and in doing so foregoes their safeguarded benefits.

In calculating the CETV, as with so many other financial calculations, certain assumptions have to be made. The CETV calculation is a 4 step process, of which there are three assumptions. The assumptions are those pertaining to inflation, gilt yield rates and assumed investment growth rates. Now that we have covered the basics, let’s get into the calculation.

The first step is simply calculating the members benefit at the date of leaving the scheme (or at the date of calculation if they are still a member). In calculating this no assumption is made as all variables are known. The duration of service, their pensionable salary and the schemes accrual rate (the rate in which benefits accrue due to employment).

If an employee is a member of a scheme and it is a 60th scheme, for each year worked (and contributed to the scheme), 1/60th of their final salary is accrued as pension benefits. Let’s assume a member had a pensionable salary at the date he left the scheme of £50,000 and he had been a member for 30 years. The calculation is simple; £50,000X(30/60)=£25,000.

Step 1 completed; onto the next step and the first assumption. The pension benefit as calculated in step 1 is at the date the member left the scheme and this now needs to be factored up to the scheme’s normal retirement age (NRA). In doing so a simply time value of money calculation is used, as well as the assumed rate of inflation. The formula is FV=PV(1+r)^n. Let’s assume our member had another 10 years until he reached the scheme’s retirement age, and the scheme actuaries assume an inflation rate of 2%, then the £25,000 will be increased to £30,474.86 (FV=25,000(1+0,02)^10).

This is the future value of the accrued pension benefits, and forms the basis for the third step; capitalising this future valued benefit. The actuaries will use the gilt rates to capitalise this value, however, such rates would need to be assumed as although known at present, they may very well change in the future. To capitalise the future benefit, simply divide such benefit by the gilt rate (expressed as a decimal). Assume the gilt rates are 3%, then £30,474.86/0,03=£1,015,828.67

This future capitalised value is the value that would need to be available in 10 years time. However, between now and then it is assumed that the transfer capital will be invested and hence we arrive to the last part of the calculation, discounting the future capitalised value to present value. In order to do this, the actuaries (of the ceding scheme), will assume a growth rate (i.e. annualised rate of growth of the capital if invested now until retirement). The longer the period between the date of calculation and the member’s NRA, the higher the discount factor would be. The assumption underlying this is that with a longer timeframe, more of the capital can be invested in equities and hence a higher growth rate can be expected.

If we assume a 4% growth rate, then the future capitalised value will need to be discounted by this over a period of 10 years. Once again, using a simple time value formula we can ascertain this present date amount. PV=FV/(1+r)^n. Let’s plug in the numbers. PV=£1,015,828.67/(1+0,04)^10=£686,257.45

And, just like that you have your CETV of £686,257.45. The best way to now understand this calculation is as follows. If we invest £686,257.45 today for a period of 10 years and achieve an annual growth rate of 4%, then in 10 years time the capital would be £1,015,828.67. At that time (10 years from date of calculation), if the capital was used to purchase an annuity of 3%, then this annuity would pay out an annual amount of £30,474.86. This annual income of £30,474.86 would have the same purchasing power as £25,000 has today, in 10 years time (if inflation is 2% per annum from date of calculation up to the member’s NRA).

This understanding can be checked using the formulas as follows:

£686,257.45(1+0,04)^10 = £1,015,828.67. Then we can take the £1,015,828 and multiply by 0,03 as representative of the 3% annuity rates. This provides us with £30,474.86. If we discount this by the inflation rate (2%) over the 10 year period (30474.86/(1+0,02)^10); we end up with £25,000 which is the exact same amount as the pension benefits owing to the member at date of leaving the scheme.

As one can see a CETV calculation is not a science due to the amount of assumptions. The purpose of this piece was not to judge the suitability of the CETV but rather to enlighten those who have received one to understand a little more how the scheme actuaries arrived at such amount.

If you want to see how this works in action, why not try a FREE calculator I have created. You can access the file by following this link. Please note, I recommend you download the Excel spreadsheet before populating it to ensure the auto-calculations all function correctly.

Do you have enough money for retirement?

One of the most common questions I receive in my practice, is that concerning retirement planning. For many of us, retirement seems a distant future and one which many people do not concern themselves with. Hopefully this will change that belief.

It is safe to say that apart from your house, your pension would probably form the largest asset you own/benefit from. In order to calculate your future target amount we need some facts and as always, some assumptions.

I am going to walk you through the steps in calculating how much money you need in retirement. Hopefully you can run your own calculations as we progress. It is my desire that everyone knows what their target is.

Firstly, we need to ascertain how much money you need in retirement. Imagine you could retire tomorrow, how much money would you need to lead a comfortable lifestyle. Remember, the 8 hours (or more) of work which you were performing now need to be filled up with leisure activities, and hence many people feel that more money would be required in retirement. Another way you can determine this amount is by asking yourself “how much more money than my current net income would I like in retirement?”.

Let’s assume your monthly figure is €2,500 per month, annualised this would be €30,000. However, as they say “the devil is in the detail.” In this instance, that detail is inflation. Inflation is simply the rate at which the price of goods increases year on year. Remember when you went with your father to the bar for your first beer (well, at least HE thinks it was your first beer). How much did it cost back then? €1,50? Nowadays you are lucky if you can find one for less than €4,50. That, ladies and gentlemen, is inflation.

Also, we need to determine how long until your retirement before we can fully appreciate the effects of inflation. Lets assume you have 25 years until you would like to be in a position to retire (financial freedom). We can now fully incorporate the effects of inflation using our beloved formula FV=PV(1+r)^n.

This calculation works out the future value (FV) of present day money (PV), at an assumed rate of inflation (r) over a pre-determined period of time (n). In our example the future value of €30,000 over 25 years (assuming an inflation rate of 2.5%) is €55,618. This means that in 25 years time, at an assumed rate of inflation of 2.5%; €55,618 would purchase you the same goods as €2,500 would today.

This is now your targeted annual income in retirement. The next step would be to calculate where this income is to originate from. That will be dealt with in a future blog post and once published it will be referred to hereunder. If you can’t wait until then, of course – feel free to send me a message and I would love to walk you through the steps.

Who needs a financial advisor anyway?

We often surprisingly hear potential clients say that they can get independent financial advice from a friend or a self-taught financial commentator. But no matter how well-meaning their intentions are, unless they are an independent qualified financial adviser, you cannot be sure that you are getting the best possible advice. So we will say it now: not everyone is qualified to provide financial advice.

To put it another way, you would not ask a friend to perform open-heart surgery on you. So why is it, when it comes to your finances, you avoid professional advice and go with what your friends say? While you may have a good idea of what will and won’t work well, only a professional has the specialist knowledge to help you maximise your finances.

In defence of my profession, I would like to present some of the misconceptions people have about the role of a financial adviser.

1. Financial advisers don’t know what my investment return will be.

It is a fact! We have no shame with the fact that we don’t know what your future return will be. Many investors that seek financial advice arrive at our doorstep with a target return in mind for their investment. However, these return objectives are influenced by past experiences, historical fund performance or a random number that will fulfil personal expectations. After all, who doesn’t want higher returns? We can refer to this return expectation as a desired return – a return target based on a want more than a need. Our role as financial advisers is to estimate the return you require to accomplish your objectives, taking into account your unique goals, time horizon, current asset base and risk tolerance, among other factors.

2. I only need an insurance policy from a financial adviser.

Your financial life is bigger than an insurance policy. Our first job is to get to know you. Financial planning is a holistic process that integrates your life’s goals with financial solutions, in order to create a financial plan. Many clients want to know: How can I save for my children’s education? Do I have enough money saved for retirement? What will happen to my children when I’m gone? How can I protect my income if I get disabled or retrenched? The goal of every financial adviser is to be the “Chief Financial Officer” of their client’s entire financial life. This work extends to investment, estate, retirement and risk planning.

3. You only need a financial adviser if you have a lot of money.

You can benefit from working with a financial adviser because you have competing financial goals – not necessarily because you have a lot of money. You may be thinking about buying a house, starting a family, travelling the world or any number of other things. All of these goals are competing for a slice of your salary, so setting your priorities and adjusting your savings percentages with an adviser becomes a requirement. Financial planning is a continuous process of anticipating and adapting to changes in personal circumstances over the long-term.

4. Financial advisers charge me fees for advice that I can get for free.

It is probably safe to assume that people take financial advice from friends rather than a professional because of the costs associated with it. While your friend is unlikely to charge you, you could potentially be losing out on more than just the adviser’s fee. To use another medical comparison, you can Google the symptoms of your illness online but that doesn’t mean that medical consultation must be free when you finally go to the doctor. Advisers like any other professional need to be incentivised for the work that they do. A qualified financial adviser is an individual whose job it is to get the most out of your finances and the benefits are likely to far outweigh the costs.

The Importance of financial planning for individuals.

My dad used to tell me that two things in life are certain. Death, and taxes. The latter is something we (to some degree), can influence by adopting to live in more tax-favourable jurisdictions. The former certainty, is unavoidable, and it is this inherent fact of life where financial planning often comes to the fore.

Can you imagine what your family has to go through in order to pay the bills, if you do not leave enough for them? Planning for the future is not something we should to; it is something we all must do.

WHAT IS FINANCIAL PLANNING?

Financial Planning is a solution which converts your goals into action plans and provides the direction and discipline to achieve these goals.

WHY IS FINANCIAL PLANNING NECESSARY?

If you have life goals, such as a worry-free retirement, education for your children at the best schools and colleges, buying a house or a car — then building a financial plan can help you achieve these goals.

Your financial plan will work towards achieving goals such as planning for your retirement, child’s education, marriage, buying a house, debt management and insurance.

Financial planning could help you:

  • Categorise your risk appetite;
  • Put a number to your goals (what is achievable and what looks difficult); map your current and future cash flows to your financial goals;
  • Map your existing assets to your financial goals;
  • Make a statement of your net worth;
  • Look at the adequacy of your insurance;
  • Determine whether you have any shortfalls or inadequacies;
  • Help you build a capital for your retirement; and
  • Make recommendations for your existing investments.

While some banks do offer a financial planning service, many find their approach to be less thorough and their impartiality must be questioned. Many people prefer going to an independent financial planner instead as they have a fiduciary relationship to their clients and not to any one institution or investment house; hereby often implementing a plan which is in their clients best interests and not in the best interests of shareholders of the institutions.

The importance of financial planning cannot be overstated. In addition to the financial implications of death, two factors matter a lot — inflation and changing lifestyles.

Inflation is a situation in which too much money chases a limited number of goods. This leads to a fall in the value of money. It is also expressed as a rise in price levels. For example, a product that costs €100 now would cost €105 a year later, assuming prices rise at 5 percent. This is the impact of rising prices over one year. Over 30 years, assuming that inflation continues to rise at 5 percent, the same product would cost you €432!

Financial planning can ensure you are better equipped to deal with the impact of inflation, especially in retirement when expenses continue but income streams dry up.

The second factor is changing lifestyles. With higher disposable incomes, it is common for individuals to upgrade their standard of living. For example, cars were considered luxuries not too long ago but are a necessity today. Financial planning has a role to play in helping individuals both upgrade and maintain their lifestyle.

Moreover, there are contingencies like medical emergencies or unplanned expenditures. Sound financial planning can enable you to mitigate such circumstances, without straining your finances.

I strongly recommend all individuals to seek financial advice to assist them in achieving their goals. For a free consultation, please comment to this article and I will get in touch with you. Should you be outside of Europe and seek financial advice, I have some great professionals within my network who I can put you in touch with.

The Power of Compound Interest

Many Individuals are unfortunately ill-prepared for retirement, and it’s an unsettling prospect that so many citizens of this modern day world may not be able to support themselves in their golden years.

However, the beauty of compound interest means that if you start saving from an early age, investing in your future doesn’t have to be the heavy financial burden that many people fear (and thus postpone). The power of compound interest actually makes saving from an early age much cheaper and less stressful than if you were to put off saving until you’re older.

Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time”, and he declared it to be “the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”.

This is best illustrated by means of an example:

Based on a growth rate of 10% per annum, if one saves €1,000 a month, the capital amount after 20 years would be €759,300. If one saves €1,000 per month for 40 years, the value would be €6.3 million… The total contributions for the client who saved for 20 years was €240,000 and the contributions of the client who saved for 40 years was €480,000, yet the difference in their values at retirement was a massive €5.5 million.

This is because compound interest is the interest calculated on the initial principal, compounded with accumulated interest. It is essentially the result of reinvesting interest so that interest is then earned on the principal sum and previously-accumulated interest combined. To put it simply, it can be thought of as ‘interest on interest on interest,’ and it will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.

The company that you work for may make monthly contributions to your retirement either in addition to your wage or through salary sacrifice. Accordingly, if you begin with your company retirement fund at age 25, then 19% of your salary should be sufficient should you continue with this for the next 40 years and not cash-in your funds on resignation or retrenchment, but rather preserve them. Should you start working later, then you would need to invest a higher percentage of your salary to compensate for your lack of compound growth in previous years.

Time is of the essence when it comes to taking advantage of the effects of compound interest to build a healthy savings pot that will provide for you in your autumn years, as well as potentially allow you to support your children with their financial goals. The bottom line is that the longer you wait to start saving, the more money you will need to save to achieve the same financial goal. And this is particularly the case when it comes to retirement savings, as this could benefit from a 40-year saving term.

The power of compound interest lies not in saving vast amounts, but instead when you start saving. Don’t underestimate its power, and don’t hesitate to arrange a meeting to find out how much you need to save per month to reach your retirement goals. Calculations will be based specifically on your current age, desired retirement age, and future requirements, so don’t delay in making compound interest work for you.

Please note that all figures in this post are average examples and don’t constitute financial advice. Each plan is unique and needs to be tailored inside of a host of influencing factors.

If you want to see how compound interest works in a real life situation, why not simply try my personally made compound interest calculator. To access this you can simply follow this link. What’s best though, is that it is FREE; and…I will not even ask you for your e-mail address. Simply download the editable Excel sheet and populate it as you wish. I am sure you will find the results rather impressive!

Want to see this calculator in action, watch my video here.