How to avoid sleepwalking into an uncertain and unrewarding retirement
Back in August last year, I wrote a blog on this website challenging the old rule of thumb that suggests investors should match their bond allocation to their age.
The adage goes, for example, that if you are 20 years of age you should hold 20% in bonds and the rest in equities. As you get older, you should switch your investments from bonds to equities and, for example, by the time you are 60, you should hold 60% in bonds and 40% in equities.
While our investment portfolios should change a lot over the years, I feel this particular way of thinking is out of date. With fewer people now buying guaranteed-return annuities at retirement and more and more people living longer, our money needs to last longer too. And while no-one should take on any more risk than they can stomach, de-risking too much as we enter retirement could be a costly mistake.
Seven Investment Management (7IM) seem to agree and have written a discussion paper on the subject. Their findings suggest that the strategy of reducing investment risk as retirement approaches may leave millions of people running out of money towards the end of their lives. As the company points out, the world has changed. With a huge number of default pension funds automatically reducing risk as retirement approaches, many investors are sleepwalking into an uncertain retirement.
In their research, 7IM looked at a number of scenarios, modelling returns for two investors who each saved an average of around £7,500 a year from the age of 30 to 60 (starting with £500 and increasing by £500 in each year of employment), retiring with an annual pension of £22,000 a year.
One saver invested in a moderately cautious portfolio targeting a return of 4% a year; the other took a step up the risk ladder, investing in a balanced portfolio targeting a return of 5% a year.
At retirement, the first had a portfolio worth around £375,000 and the second had £425,000. The first ran out of money at 86, having withdrawn £22,000 per year. The balanced investor still had around £275,000 left at this point, demonstrating how a very small increase in investment risk can make a remarkable difference to outcomes when pension pots are at their greatest, in retirement, and the effects of compounding are at their most potent.
The value of your investment can fall as well as rise
As we are always reminded, however, markets can go down as well as up and it's usually not in a straight line. 7IM have acknowledged this by running the same portfolios through a range of outcomes, drawing on the historic volatility experienced by investment portfolios between January 2004 and January 2016 – a period that included the global financial crisis and significant stock market falls as well as gains.
Income was taken out monthly to reflect real life, ensuring any losses (when markets fell) were locked in. On a scale of 1 to 10 with 10 being financial armageddon, they took a 'bad' scenario as being around 8. In this scenario, the moderately cautious investor ran out of money at 79. The balanced investor’s money lasted another four years – to 83.
Now, as in August last year, my recommendation is that we shouldn't limit ourselves to old rules of thumb and traditional 'retirement' assets. We can continue to diversify our portfolios in meaningful ways no matter what our age and most of us can afford to keep more of our money in equities for longer, giving our retirement pot the chance to grow or replenish.
If you are not confident building an appropriate portfolio for yourself, there are a number of very good, actively managed multi-asset funds available where the fund manager will choose the assets they believe will work best at different times in the market cycle.
For example, Schroder MM Diversity Tactical has a neutral position of 80% in equities, 5% in fixed interest/cash and 15% in alternatives (property, hedge funds, commodities). Within each area, there is sufficient scope to use tactical overlays to enhance value; however, the managers keep a close eye on capital protection.
Premier Multi-Asset Growth and Income is another option. It is designed to grow investors’ capital over the long term, while paying a modest and rising income (currently 2%*).
Slightly less risky options are M&G Episode Income and Artemis Monthly Distribution. The former is managed in a very different way to its peers in that the manager constantly looks for value created by investor irrationality and then takes positions that reflect those views. It has a current yield of 2.5%*. The Artemis fund is run by two managers I rate very highly – one specialising in bonds and the other in equities. The fund’s natural split is 60% bonds and 40% equities, although it can shift quite significantly, depending on how the managers feel about global economies, stock markets and companies. It is currently yielding 3.76%*.
And for those who really don't want too many sleepless nights, Jupiter Distribution fund is an option. It's default position is 70% fixed income and 30% equities, but while exercising caution and diversification, the fund has a record of consistently outperforming its sector average and is a strong contender for cautious investors.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius's views are his own and do not constitute financial advice.
*Source FE Analytics as at 30 April 2017.
The 7IM research was reviewed by an actuarial firm, OAC, who deemed our methodology as appropriate and conclusions consistent with analysis up to the 90% probability level.