Squaring the Lifestyle Circle with John Lucey
10 July 2020
Squaring the Lifestyle Circle
Today I look at the apparent conflict between lifestyle investment strategies for pension funds and appropriate investment strategies for ARFs.
Lifestyle strategies have been an important element of pension plans for many years. They work by reducing the risk profile of retirement savings when approaching retirement.
Generally speaking, investors are happy to focus on higher risk investments such as equities when retirement is in the distant future. These investments have the potential to generate high returns but also tend to be more volatile than other assets and are therefore subject to market falls. Over a long period of time higher risk investments tend to deliver reasonably strong growth. Unfortunately, as an individual gets closer to retirement there is less time to recover if markets fall. Furthermore, people at that stage of their lives tend to be more risk averse than when they were younger.
Lifestyle strategies are designed to cater for these circumstances by gradually shifting money into lower risk assets such as bonds which have lower growth potential but are much less vulnerable to falls in the market. These strategies remain important. Preserving the value of the fund in the run-up to retirement tends to be a high priority for the great majority of pension investors.
However, the move away from annuities in recent years calls this approach into question. Annuities, by their nature, are low risk investments. Indeed, from the perspective of many investors they are deemed to have no investment risk – the only real perceived risk is early mortality. An annuity purchase on retirement therefore aligns perfectly with a standard lifestyle strategy. But annuities have become inordinately expensive for most pension investors. Continuing low interest rates and bond yields have depressed returns to the extent that annuity purchases have become a relative rarity.
The alternative is to purchase an approved retirement fund (ARF) which, of necessity, will have to invest in at least some risk assets if the fund is to outperform annuities. Therein lies the conundrum for pension investors. Having spent the years approaching retirement dialling down risk exposure investors now have to dial it up again.
This circle is by no means impossible to square, however. It is not a zero-sum game nor is it a question of moving from no risk to maximum risk. While the lifestyle strategy is designed to secure the investor’s fund up until retirement, what happens after that is another question. The mix of assets chosen for an ARF is crucial in this respect. It can be weighted towards lower risk bonds or anywhere else on the risk spectrum depending on the attitude of the investor.
Indeed, it is even possible to combine an ARF with an annuity purchase in order to guarantee a minimum pension amount which would be topped up from the returns achieved by the ARF. In this context, it is imperative that the investor has a clear idea of the strategy to be pursued post retirement. A standard lifestyle strategy which moves much of the pension fund into bonds could suffer quite a dramatic capital impairment in the event of a rise in long term interest rates.
This emphasises the growing need for professional advice as people approach retirement. Risk appetite must be open to constant re-evaluation in light of the overall financial circumstances of the investor. Retirees with other assets and sources of income to draw upon will be in the happy position of being able to dial up risk should they so choose. On the other hand, those who are solely or mainly reliant on their pension fund for their income in retirement will probably need to be that bit more cautious.
Director, Invesco – email@example.com
By John Lucey, Director
John has over 20 years’ experience in the Irish pension industry having previously worked with Coyle Hamilton Willis and Irish Life. John is an Associate of both the Irish Institute of Pensions Managers and the Pensions Management Institute.