David Davison explains how the Growth Plan 3 pension arrangement works.

I’m often asked by clients about the value of the guarantee offered under the Growth Plan 3 arrangement and if it has any value. To answer the question you really need to understand what the guarantee provides and what risks pension savers face up to and at the point of retirement.

Members with benefits in Growth Plan 3 have a guarantee that the value of their fund at the end of the year, after plan charges, will not be less than the value at the start of the year plus the full amount of any new contributions paid. So effectively members have a guarantee that their fund value won’t fall after the payment of charges.

In providing this guarantee the pension plan trustees manage this risk by investing all the assets in low risk deposit accounts to ensure the value can’t fall but which equally means it’s not likely to rise by very much, if at all, given current interest rates.

So the guarantee therefore protects members against the risk of a fall in the capital value of their fund however this risk is only one which pension savers face and yet it tends to be one which receives a disproportionate level of attention.

Pension savers are also exposed to inflation risk. If the level of inflation exceeds the level of return achieved then the value of the assets held falls in real terms. For example, if you had an asset worth £1,000 which achieved no return over a 12-month period while inflation was 5 per cent then in real terms at the end of the year your £1,000 would only be worth £950. Clearly the longer the period over which this happens then the greater the impact – over 10 years it would reduce the value by 40 per cent and 65 per cent over 20 years. This is why those investing for a long period to retirement tend to focus on achieving real returns above inflation and therefore tend to invest in growth stocks such as equities and property as a real rate of return over similar periods would have seen the values increase in real terms by 60 per cent and 160 per cent respectively.

Whilst there will be a degree of fluctuation in returns in these asset classes over time this only becomes significant if it happens at or very close to the point where an individual is securing an income and at that point a capital guarantee can be of value providing it is of the right type.

At retirement individuals will be looking to convert the value of their defined contribution pension fund in to an annual pension income having in most cases drawn their maximum tax free cash sum (typically one quarter of the fund). At this point they are exposed to a conversion risk, namely that the value of the assets they hold do rise or fall in a way which replicates the rise or fall in the cost of buying an income. Cash assets do not hedge against the risk of conversion rate changes as conversion rates (annuity rates) broadly reflect interest rates in the government bond market so the pension holder would have to be invested in government bonds to mitigate this risk.

Given the above, most defined contribution schemes offer members a “lifestyle” investment option which invests in growth stocks up until 5 or 10 years from retirement followed by a gradual move to cash and government bonds to reflect the tax free cash entitlement and the conversion of the remaining fund to an annual income. These funds tend to be the default solution to managing the various risks members face and whilst not perfect they tend to be more suitable than single asset class investments.

So the Growth Plan 3 guarantee locks members of all ages in a single asset class investment which is unlikely to meet inflation risk through to retirement or the conversion risk at retirement but guarantees that the capital value cannot fall.
There is undoubtedly a price to be paid for this guarantee and individuals need to consider if that price is worth paying or if they would be better considering other investment options which better reflect their age and risk profile. The investment decision is crucial in maximising the level of pension benefit from any scheme and members should consider taking advice to make sure they get the best value for their and their employer’s contributions.

This material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent professional advice for your own particular situation.