How to calculate the worth of a fixed income product?

Costabit

I am having a bit of a mind block on this as am unsure how to include my fixed income products (final salary pension and state pension) in my overall asset allocation alongside SIPPs ISAs cash etc.

If I have a £10K per annum pension which I am drawing on now, with RPI increases and 2/3rds widow benefits, what £ figure could you allocate to this?

And the same with a full state pension which I will get in 4 years, what £ figure would you give this?

I realise that it is not a definite finite science but am really not getting how to calculate this, is there a way of doing it that anybody knows.

Grateful for any thoughts.

 

 

Notnewnotold

I suppose the obvious counter question is - why would you want to? Neither have any value as such because it can't be realised. You take the income, there is no 'pot' of value behind it as an alternative. 

For lifetime allowance purposes (which is the only reason I can think of ever needing a notional valuation), then for your DB pension annuity, it's 20x the annual income, plus any initial lump sum you took. For state pension it's zero, as that doesn't form part of the LA...

In reality, CETVs for DB schemes, where available, tend to hover around 35x annual income amounts, sometimes a bit less, sometimes quite a bit more depending on indexation, GAR provisions, spousal benefits etc. But it's not a simple formula, these are quite complicated actuarial calculations... 

Hopefully you're not trying to use it to prove to a private bank or wealth manager that you meet their thresholds to be worth taking on as a client 

shinytop

I use what sum would produce the same income at a nominal SWR, say 3.5 or 4%.  It's useful to do because it gives a total view of your provision.  I know I'm about 60% equities in my investments but 20% if I include my DB pensions and even less if I include SP.  Academic but useful to do (IMO). 

Malthusian

A State Pension has no value. As per the High Court's ruling against WASPI, it is a State benefit and not a contractual entitlement. It expires on your death, the terms can be amended by the Government at will, and it is derived not from your money but from taxing current taxpayers' money. It is not an asset.

It's like trying to value the air in your house. Just because it's there and very important to your lifestyle and unlikely to go away any time soon doesn't mean it's an asset you can put a £ figure on.

The final salary pension by contrast is a contractual entitlement, but the idea of giving it a value is a very philosophical exercise unless there's a possibility that the scheme will offer to buy it back off you - which occasionally happens with very small scheme pensions in payment but it sounds like it's pretty unlikely with this one.

If this is an asset allocation exercise, then it's a bit of a category error trying to include the State Pension and your final salary pension. You can't sell part of your State Pension and reinvest it in equities when the markets fall.*

Using the 20x multiplier for a defined benefit pension already in payment is potentially misleading. The 20x figure is an arbitrary multiplier which HMRC uses for a defined benefit pension that is about to be drawn. But if yours is already in payment, yours is less valuable than 20x because you've got fewer payments to look forward to than somebody just about to draw one.

The only meaningful value is "what would you sell it for" and "what would the scheme or a theoretical third party offer to buy the income stream from you" - but you can't sell it and nobody is going to buy it so it's a bit like trying to put a value on your infant children.

[edit] *Another reason it's not a great idea to try to include defined benefit pensions in an asset allocation exercise is that people will say things like "I have £500,000 in my private pension fund, and I'm middle-of-the-road when it comes to risk so I guess I should have 40% in bonds. But I have a State Pension and a defined benefit pension that total £18,500pa, and those are fixed income which is basically the same thing, so with £370k of bonds I've already got my 40% and should whack 100% of my private fund into equities." Then their equity fund falls by £200,000 and they panic and cash it in because they didn't actually have the stomach for 100% equities. People only take a holistic view while everything is going up, when markets start falling they compartmentalise.

Costabit

Notnewnotold said:

I suppose the obvious counter question is - why would you want to? Neither have any value as such because it can't be realised. You take the income, there is no 'pot' of value behind it as an alternative. 

It’s an asset allocation exercise for my own info really.
Am intending to use any info gleamed to help me decide if I have enough / too much in equities

Costabit

shinytop said:

I use what sum would produce the same income at a nominal SWR, say 3.5 or 4%.  It's useful to do because it gives a total view of your provision.  I know I'm about 60% equities in my investments but 20% if I include my DB pensions and even less if I include SP.  Academic but useful to do (IMO). 

Using SWR is an interesting thought thanks.
Like you , I know that I have got 60% equity but will be interested in how much that figure drops when including DB pensions

Costabit

Malthusian said:

[edit] *Another reason it's not a great idea to try to include defined benefit pensions in an asset allocation exercise is that people will say things like "I have £500,000 in my private pension fund, and I'm middle-of-the-road when it comes to risk so I guess I should have 40% in bonds. But I have a State Pension and a defined benefit pension that total £18,500pa, and those are fixed income which is basically the same thing, so with £370k of bonds I've already got my 40% and should whack 100% of my private fund into equities." Then their equity fund falls by £200,000 and they panic and cash it in because they didn't actually have the stomach for 100% equities. People only take a holistic view while everything is going up, when markets start falling they compartmentalise.

Thanks Malthusian
I think that is the most salient point. It has calmed me down re.any thoughts on increasing my equity %

Prism

I would plug the numbers into an annuity calculator which should then give you a cost of what that type guaranteed income would be worth. Thats how the ONS do it for example to come up with stats like average pension savings per capita.

[Deleted User]

I think it should be included in asset allocation.  Lets take an extreme case of someone with 100k per year DB income and 100k DC pension.  How should the latter be invested?  In my mind there is no doubt that it should all go into equities because the individual’s finances can withstand equity fluctuations without blinking an eye.  

This isn’t a hypothetical example; families with large DB pension provision tend to be way too conservative with investable portion which ends up costing them in the long run.  Same as young people who ignore salaries, which is effectively a fixed income source.  So, the real question isn’t “can I sell my annuity for GBP in the pocket?”  Its “How does it impact my ability to withstand market fluctuations?” 

Another example: X is selling some of his bonds to buy an annuity. Does it mean he now needs to sell equities and buy bonds to get back to 60/40?  No way. 

Could this approach end up costing the individual because of behavioural problems? Of course. But having unreasonable amount of FI because of ignoring DB/state pension is a behavioural problem too.  Saying “lets make a mistake to avoid future mistakes” does not make sense to me. 

The other way to look at it, is by focusing on the total size of your cash flow stream.  If your needs are mostly covered through DB/state pension income, then your free funds should be in equity. If your income is 90% dependent on your DC pot and you only just have enough then you need lots of FI as you can’t withstand fluctuations. But ignoring DB income is always the wrong answer.

Personally I don’t count DB pensions as part of my net worth but I do consider them as fixed income.  For purposes of asset allocation I do x25, but the actual number doesn’t matter. Its not a precise science.  And I am not getting any DB income yet, but once I do the asset allocation will be changed to reflect that. 

shinytop

Malthusian said:

A State Pension has no value. As per the High Court's ruling against WASPI, it is a State benefit and not a contractual entitlement. It expires on your death, the terms can be amended by the Government at will, and it is derived not from your money but from taxing current taxpayers' money. It is not an asset.

It's like trying to value the air in your house. Just because it's there and very important to your lifestyle and unlikely to go away any time soon doesn't mean it's an asset you can put a £ figure on.

The final salary pension by contrast is a contractual entitlement, but the idea of giving it a value is a very philosophical exercise unless there's a possibility that the scheme will offer to buy it back off you - which occasionally happens with very small scheme pensions in payment but it sounds like it's pretty unlikely with this one.

If this is an asset allocation exercise, then it's a bit of a category error trying to include the State Pension and your final salary pension. You can't sell part of your State Pension and reinvest it in equities when the markets fall.*

Using the 20x multiplier for a defined benefit pension already in payment is potentially misleading. The 20x figure is an arbitrary multiplier which HMRC uses for a defined benefit pension that is about to be drawn. But if yours is already in payment, yours is less valuable than 20x because you've got fewer payments to look forward to than somebody just about to draw one.

The only meaningful value is "what would you sell it for" and "what would the scheme or a theoretical third party offer to buy the income stream from you" - but you can't sell it and nobody is going to buy it so it's a bit like trying to put a value on your infant children.

[edit] *Another reason it's not a great idea to try to include defined benefit pensions in an asset allocation exercise is that people will say things like "I have £500,000 in my private pension fund, and I'm middle-of-the-road when it comes to risk so I guess I should have 40% in bonds. But I have a State Pension and a defined benefit pension that total £18,500pa, and those are fixed income which is basically the same thing, so with £370k of bonds I've already got my 40% and should whack 100% of my private fund into equities." Then their equity fund falls by £200,000 and they panic and cash it in because they didn't actually have the stomach for 100% equities. People only take a holistic view while everything is going up, when markets start falling they compartmentalise.

It doesn't matter where my state and DB pensions come from or that I can't cash them in; they have a value to me and if I didn't have them I'd have to find the money to live on from somewhere else.  And rather than making me splurge all my DC pension on high risk equities; having them does the opposite because when markets drop I have the confidence to leave my well-diversified 60% equities portfolio alone.       

It also helps remind me how lucky/well off I am to have a decent DB pension.

Linton

Deleted_User said:

I think it should be included in asset allocation.  Lets take an extreme case of someone with 100k per year DB income and 100k DC pension.  How should the latter be invested?  In my mind there is no doubt that it should all go into equities because the individual’s finances can withstand equity fluctuations without blinking an eye.  

This isn’t a hypothetical example; families with large DB pension provision tend to be way too conservative with investable portion which ends up costing them in the long run.  Same as young people who ignore salaries, which is effectively a fixed income source.  So, the real question isn’t “can I sell my annuity for GBP in the pocket?”  Its “How does it impact my ability to withstand market fluctuations?” 

Another example: X is selling some of his bonds to buy an annuity. Does it mean he now needs to sell equities and buy bonds to get back to 60/40?  No way. 

Could this approach end up costing the individual because of behavioural problems? Of course. But having unreasonable amount of FI because of ignoring DB/state pension is a behavioural problem too.  Saying “lets make a mistake to avoid future mistakes” does not make sense to me. 

The other way to look at it, is by focusing on the total size of your cash flow stream.  If your needs are mostly covered through DB/state pension income, then your free funds should be in equity. If your income is 90% dependent on your DC pot and you only just have enough then you need lots of FI as you can’t withstand fluctuations. But ignoring DB income is always the wrong answer.

Personally I don’t count DB pensions as part of my net worth but I do consider them as fixed income.  For purposes of asset allocation I do x25, but the actual number doesn’t matter. Its not a precise science.  And I am not getting any DB income yet, but once I do the asset allocation will be changed to reflect that. 

If you need your investible assets to produce a small income to supplement your guaranteed income why not just focus on that?  You should not need to invent extra "bonds" so you can tick the 60:40 box.  60:40 may be appropriate for a particular set of circumstances, it's not a rule that must be obeyed with the facts adjusted to make it so. With a DB pension modelled as a very expensive Index Linked Gilt you may only be able to meet the 60:40 value if you leveraged your equity!   No, just devise an appropriate allocation for the requirement,

It seems to me that if you have more assets than required to support your lifestyle that is an opportunity for derisking rather than one for accumulating even more money that you dont really need.