For decades, a traditional strategy that many investors have adopted – and in particular for their pension pots – has been an approach that reduces the level of investment risk that they take as they get nearer and nearer the day they retire.
Known as the ‘lifestyle’ approach, the mix of investments alters as individuals reach pre-set ages. It encourages investors to invest in riskier assets at the outset of their career as they try to build up their savings. The logic goes that they should be able to ‘afford’ that risk as they have the time for their portfolios to ‘recover’ in the event of a big set-back in the markets, such as the one we saw in 2008.
As investors get older, they then steadily shift into investments that are deemed to be less risky – stepping down the level of investment risk as they approach retirement. The shift in risk is achieved by switching from stocks and shares (aka equities or ‘riskier’ assets) to bonds (seen as ‘safe havens’) as you get older. So, you might start off with as much as 70% of your portfolio in stocks and shares and 30% in bonds, and steadily move a percentage of those equity assets into bonds as you hit those age milestones. By the time you retire, the majority of your assets would be invested in the traditional safe havens of government bonds or Gilts.
While annuities gave us certainty as to how much we would get each year, it was important not to suffer a big investment hit just before purchase. This supported lowering the level of investment risk over time and fixed income made sense in that world. By moving largely into bonds as retirement approaches, the risk of rising annuity costs undermining your income in retirement is circumvented as any decline in interest rates (and, by implication, the income from annuities) is offset by an increase in your portfolio value.
The new world
But the world we live in has fundamentally changed:
1. Annuities are no longer the sole answer
In April 2015 the pension’s world changed. Investors were no longer forced to buy an annuity when they retired. There was no longer a definitive cut-off point in life where pension savings get irrevocably swapped for a secure income. And, as a result, time horizons for the investment of retirement savings increased.
2. Bond yields have fallen
200-year record lows for interest rates have, in the meantime, reduced our expectations of future investment returns from bonds. This is also a key reason why annuities are currently seen to be ‘expensive’. The underlying asset for many of these investments and other pension products (i.e. bonds) are not providing investors with the same level of income they used to. As a result of the lower returns available, the incomes currently promised for annuities are lower.
3. More years being lived
We also now live much longer than our parents did, and that longevity of life has not stopped extending. In England, life expectancy at birth for boys increased from 73.7 years in 1991 to 79.5 years in 2012. A newborn baby boy in England in 2012 can expect to live almost six years longer than the same newborn two decades before. So savings have to last longer.
It is increasingly a personal responsibility and not a government one. With investors no longer forced to buy annuities, those longevity dynamics that were increasingly affecting annuity market decision makers are now being faced by individual investors. Our savings need to work harder to beat inflation, which is making a come-back, without the support of interest rates. All-the-while, our savings are having to stretch further as we live longer.
It was this combination of events that led 7IM – one of Wren Sterling’s investment partners – to run some research into investors’ options. We have always aimed to provide our clients with more predictable returns. We manage money in a way that – over the medium to long term – provides each of our investors with a specified range of returns that we would work to deliver so they know what their pot of money would provide. By using the historic returns and past performance as a basis for our research, we looked to delve into the decisions investors could make.
This research threw up some interesting results. We learned, for example, that actually taking more risk early on in an investor’s career didn’t actually make much of a difference. There simply wasn’t enough in the pot to build on until much later in life when – after you’d been investing a regular sum over a long period – you had more money ‘at stake’. However, lifestyle strategies would look to lower the risk profile of investments precisely at this very point in the build-up of your savings pot i.e. as the retirement date and annuity conversion approaches, and when the power of compounding becomes most powerful i.e. investment returns generate their own investment returns.
Past performance is not going to provide a roadmap as to how investments will perform in the future, and investors can lose money – to the extent where those losses are actually eating into the money originally invested. However, every scenario we ran highlighted another risk: the risk that you could outlive your savings.
If you have a pot of money and have to take out 5% each year to cover life’s expenses, but you’re only making 3% on your money, your overall pot would probably shrink over time. Before, if you were only living for 15 years, you could reasonably outlive any dwindling savings. Now you may have to double that drawdown period. Solving this problem requires a balancing of the various sources of risk. So you need to do a combination of saving more while you’re working (savings risk), look to retire later (job risk), take a lower income in retirement (lifestyle risk) or seek a higher investment return (investment risk).
Here we have to be careful – we are definitely not saying everyone needs to take more investment risk. Risk is a very personal choice. But taking some additional investment risk, while the return on bonds is so low and investment time horizons are extending into the time of retirement itself, has the potential to reap rewards. This is especially the case when the investment pot is at its largest, which is typically just as retirement approaches.
So, given people now have more choices and there are a number of ‘levers’, we believe that they should have the right conversations to look at all of them and consider the implications. Here, they may need the help of professional wealth planners – such as those who work for Wren Sterling – to help them make decisions that are right for them and ensure that they have enough money to enjoy all of their retirement.
Seven Investment Management is one of Wren Sterling’s preferred panel of investment managers. All views are that of Seven Investment Management and do not necessarily reflect those of Wren Sterling.
This article is for general information and is not intended to be relied upon by you in making or not making any investment decisions. It is recommended that you seek independent financial advice before making any financial decisions.
Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority. Member of the London Stock Exchange. Registered office: 55 Bishopsgate, London EC2N 3AS. Registered in England and Wales No. OC378740.