An Alternative View of Duxbury - by Debbie Phillpotts

Date: 11/11/2009

“As has been said more than once, the only thing one can be sure about Duxbury is that the figure is likely to be too high or too low. It remains however a useful guide”. Wall LJ (Fielden v Cunliffe 2005). 

2005 may be recent history chronologically, but it seems an aeon ago in economic history. If Duxbury was no more than a useful guide then, where does it stand today? Does it still have any credibility or, if there ever were any certainties, can we still rely on them today? Perhaps it is time for a re-think.

I am a financial adviser, and my work often revolves around using economic forecasting to fulfil absolute requirements. I am therefore particularly interested in the theory behind the Duxbury tables and, specifically, the relationship between the theoretical calculation of a capitalised sum for income and the practical issues in reversing that calculation – ie, realising the target income stream from the capitalised sum.

Securing income from capital is a central theme in financial planning at every stage of life (and death) – whether it’s using a family trust to pay school fees, providing family income from life insurance, planning for a comfortable income in retirement – or using a capital sum from a divorce settlement to provide income for life. Not surprisingly, it is a highly regulated area of advice, the regulator’s primary concern being to ensure that realistic growth assumptions are used and that the proposed investment model meets the client’s own risk tolerance. It would be unusual, for instance, to suggest the same investment proposal to “widows & orphans” and to a city broker.

Unfortunately, this is not an area that lends itself well to the absolutes that the regulator would like us to identify.

Clients who might confidently have described themselves as high risk investors when we had a bull market of Celtic tigers and Asian dragons, may now think twice just making a deposit with their bank. It is my responsibility to try to define the client’s core “investment risk tolerance” and to explore the assumptions that that they are prepared to make.

To take an example, I might have a client in their mid forties with concerns about their income in retirement. They might want advice on securing a post tax annual income of, say, £100,000 in today’s terms from their 60th birthday. Before I work on their strategy, I shall need to discuss and agree certain assumptions with them:

• Shall we agree to base calculations on current taxation legislation? This could incline me towards a portfolio targeted to achieve capital growth, currently taxed at up to 18%, rather than income, which is soon to be taxed at up to 50%. But how long will this artificial situation be maintained?
• What level of indexation would be realistic when projecting forward £100,000 into future values? Can we assume that CPI targets will be met? What will the long term relationship be between inflation and investment returns?
• What growth & income returns from capital should be assumed? And thus, what capital sum will be required to generate the target income?
• How does my client approach investment – will they risk capital and live with volatility in order to achieve potentially higher growth? If not, are they willing to “tie up” larger amounts of capital for lower, more secure growth?
• What is “secure”? Is cash secure, when returns are historically below inflation? Are the weakest banks, with government backing, now the strongest?

It is vital that, from outset, the investor appreciates the level of risk that is being taken, that they agree with this and that they believe that the underlying assumptions appear realistic. Our regular reviews will keep the strategy on target but, most often, there is no immediate guarantee that targets will be met and there is no infallible “one size fits all” solution.

I have provided this background in order to draw a contrast with the procedure that the Court follows when consulting the Duxbury tables in isolation.

For a Duxbury based solution to be found, just three simple questions must be answered:

• What immediate post tax income does the settlee require?
• What sex are they?
• What age are they?

It may not be practicable for the Court to tailor every settlement to the settlee’s risk profile and economic beliefs, but the Duxbury tables are so simplistic that things tend to come horribly unstuck when the settlee later seeks financial advice on reversing the capitalisation process – ie, withdrawing an income stream from their capital sum.

To take an example, Duxbury tells us that, if the settlee – let’s say Patricia - is age 60 and needs a post tax income of £100,000, then she requires a capital sum of £1,843,000.

When Patricia then keeps her appointment with me for further advice, she may well be expecting a “joined up” extension of the Duxbury process. If Duxbury allows for an income requirement to be capitalised, should it not equally guarantee a process for that specific income to be secured?

However, there are two obvious “solutions” for me currently to present to Patricia, neither of which she may find palatable.

Investment

For simplicity, we could assume that the marginal rate of tax on Patricia’s income is 30%. To achieve £100,000 net income each year, she therefore requires £142,857 gross. To achieve £142,857 gross from a capital sum of £1,795,000, she will therefore need to withdraw some 7.75% each year. Investment management fees of perhaps 1.5% will also be deducted. Total annual withdrawals will therefore be some 9.25%.

If we secure a real return on capital of 3.75% (as per Duxbury), Patricia’s capital will all be spent before she is 75. Bearing in mind that an average life expectancy would grant her another 9 or 10 years beyond this, this is not good – and, of course, her true life expectancy could be far in excess of this.

An extreme, but educational, example would be Jeanne Louise Calment who died in 1997 at the age of 122, the world’s oldest woman. She too required an income and a lawyer took an ill judged bet on her life expectancy. François Raffray agreed to pay Mme. Calment an annual amount equivalent to one tenth of the value of her apartment, with the apartment passing to him on her death. She was then 90. Unfortunately for M. Raffray, not only did she survive more than thirty years, but he died first, in December, 1995 at the age of 77. His wife had to continue the payments.

So, when I sit down with Patricia initially to discuss an investment based solution, it may not be a comfortable conversation for her; she will find that compromises will need to be made and difficult facts accepted.

Investment modelling would indicate that a portfolio with the following asset allocation would achieve sufficient growth for Patricia’s income to continue, on an indexed basis, throughout her lifetime.

• 80% Equities
• 10% Property
• 10% Hedge Funds

But would I feel happy recommending such a high level of investment risk to an unsophisticated investor who would have specifically instructed me that she is expecting financial security for life from her settlement?

Patricia would certainly have had an exciting time over the last twelve months learning all about V shapes and double-dips, watching equity markets lurch like ships in a storm and listening to Armageddon analysis on the radio. I am sure she would have been delighted to provide feedback on the suitability of my recommendation.

Purchased life annuity

Perhaps I should advise Patricia to purchase an annuity. This is a low risk solution with a high level of guarantee (the risks being that inflation may be greater than the annuity indexation, or that the annuity provider defaults).

The current rate for an indexed, Purchased Life Annuity (PLA) for a 60 year old, non smoking woman is around 4%. Her £1,843,000. settlement would therefore secure Patricia annual income of around £74,000 gross. PLAs are subject to favourable taxation, but Patricia is still left significantly short of her target income.

One might have thought that the Duxbury figures would broadly follow PLA rates, given that the PLA model mirrors what the Duxbury tables appear to aim to achieve – ie, a guaranteed income for life, precisely using up the individual’s capital & interest over their lifetime, with no balance remaining.

However, based on the indicative rates below, it is apparent that in fact the Duxbury tables assume very much higher returns. This means that the most appropriate solution is unfortunately not adequate.

Interim revision of the Duxbury tables by the At a Glance editorial team is certainly a step in the right direction and does recognise the economic conditions in which we find ourselves today. But with the base rate at 0.5% and long term investment returns forecast to be lower than we have seen historically, will the reduction be anywhere near adequate?

As quoted above, Lord Justice Wall expects that the only certainty about Duxbury is that the figure is likely “to be too high or too low”.

But we do not have to live with this situation; systemic improvements can be made. We simply need consensus as to whether these should be limited to a full scale review of the tables – or, ideally, whether we can aim for a root and branch overhaul involving an annuity or insurance based alternative.

At present, for any but the youngest divorcees, the tables mean that any settlement is only ever likely to prove too low. Unfortunately, the best income solutions for those on whom a Duxbury settlement is made may be either an early death or – worse? – another marriage to a wealthy partner.

It must be time for a radical re-think.

Debbie Phillpotts DipPFS CFP
Senior Financial Planning Consultant

Postscript to the Financial Planners View - Smart Financial Planning in Divorce Cases by Simon Bruce, Farrer and Co LLP 

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