The risky business of retirement

A lifestyle strategy gradually reduces the risk profile of your retirement savings the closer you get to retirement. Pension funds often have lifestyle strategies built in and their purpose is to progressively de-risk investments by allocating more and more funds to cash and bonds as you reach retirement age.

But what are the alternatives in a world where many more people are opting to invest in approved retirement funds (ARF) rather than annuities?

Four experts explain:

Paul Kenny, Mercer

“For members who don’t want to be hands-on with their investment decisions, they can select a ‘lifestyle strategy’. Lifestyle strategies are a mechanism to reduce investment risk appropriately and automatically for members as they near retirement. They typically invest a member’s accumulated assets in growth assets – such as equities and other assets to provide diversification – when the member has a long period until retirement.

“As the member gets closer to their retirement age, the lifestyle strategy will gradually and incrementally reduce investment risk and will phase the member’s assets to an investment strategy that is deemed to be appropriate for the benefit they are expected to take at retirement. The retirement options available to members are – subject to certain rules and restrictions – the option to take tax-free cash, purchase an annuity – ie receive a regular pension amount for life from an insurance company – or invest in an approved retirement fund (ARF). For members who are likely to invest in an ARF at or post retirement, the lifestyle strategy will reduce the investment risk taken, but not entirely, as the member would be expected to remain invested in growth assets to some degree post-retirement.

“Offering a lifestyle strategy is an appropriate investment strategy option for trustees to offer to members of defined contribution [DC] pension schemes.

“The majority of DC pension scheme members in Ireland are invested in their plan’s investment default, which typically comprise some sort of lifestyle strategy – with the actual lifestyle strategies offered differing from scheme to scheme.”

Cian Hurley, Willis Towers Watson

“Bonds have been seen by investors as a safe haven over the last 30 years and are not the safe haven they once were.

“Defined contribution investors are constrained by the need to buy and sell investments daily. This results in DC members not being able to access ideas like direct property, for example, because it could take months to sell. Although most of us will be invested for over 30 years, members may move employer. This could result in members needing to switch schemes and sell down their investments in the old scheme to move to the new.

“Where does that leave investors? Our thinking is to apply a diversified approach to pension investing. The fund range that we offer makes use of an extended range of assets beyond the traditional equities and bonds. Members are able to access more asset classes such as specialist infrastructure and REITs [real estate investment trusts].

“We do this by giving members access to investment ideas that really add to diversification. The strategy is based on the thesis that real-estate securities that own prime assets are mispriced because most real-estate securities investors are focused on high current yields rather than total returns. The lower or average yields of the securities targeted by the strategy are, therefore, viewed unfavourably by investors, which results in them being mispriced by the market.

“The strategy gives exposure to prime assets in global gateway cities using a systematic approach, which makes use of data in areas such as business and economic activity, cultural and political influence as well as property level data.”

Daniel Moroney, Investec

“Up until recently, on the day you retired you went to an insurance company with your accumulated pot and whatever the interest rates were at the time dictated the amount of income you would have for the rest of your life. In the past, when a retiree’s only option was to buy a pension from an insurance company, the size of your pension pot on the day you retired was hugely important – the larger the pot on ‘retirement day’, the larger your income in retirement.

“In those circumstances, it was vital that the size of the pot was protected as retirement approached. A sharp fall in markets before retirement day could result in a permanently lowered income in retirement – there was no time left to allow markets to recover. It made perfect sense to ‘de-risk’ significantly in the years leading up to retirement.

“That was fine and sensible under that system but with the advent of the approved retirement fund, we have a different option. The annuity option is still there but, arguably, in a low-interest rate environment it’s very unappealing. There are lots of benefits to the ARF such as you maintain control over your retirement pot and the retirement pot stays on the family balance sheet – it becomes an asset of the ARF holder and a lump of an ARF can pass to a spouse or pass to the kids, with some inheritance tax.

“If you buy an annuity and walk out and are hit by the 46A, the money disappears and the insurance company has essentially won the bet. However, with the annuity, you never have to think of investment markets again. The cheque will keep coming in.

“The ARF is simply a tax-sheltered investment portfolio from which the retiree will draw their pension income in retirement. As such, it obviously needs to be invested throughout retirement. For an individual who intends to go down the ARF route, retirement day is no longer the end of the investment journey – it is merely a stop on an investment journey that now continues until their death.

“This being the case, in general terms, it doesn’t make sense for such retirees to significantly de-risk as retirement day approaches. People who intend on taking the ARF option should be thinking in terms of their overall time horizon, including their retirement years. They may not want to decrease their investment risk once they have retired, and that is sensible, but this should be done on a measured basis. They must not lose sight of the many years of income they will need their ARF to provide. Significantly, de-risking for several years around retirement day may have material negative impact on the size of the ARF in the years to follow.”

Alistair Byrne, State Street

Alistair Byrne says people will want the asset allocation for their pension to change through life. “ A lifestyle fund or a target date fund can deliver that – the question is what allocations you use.

“You still want to have changing asset allocation through life – a lifestyle fund or a target date fund can deliver that. The question is, what allocations you use. For someone in their 20s and 30s who is beginning to save and their focus is on growing their pot, we typically recommend a portfolio that’s over 80 per cent in equities. They could potentially have some diversifying assets as well . That portfolio will serve them well throughout most of their career but as they come to retirement, even if they are using an ARF and they’re planning to draw down over time rather than take cash or buy an annuity, having 80 per cent equities in their portfolio is likely to be too aggressive.

“We would be suggesting at that stage 40 per cent in equities, a higher proportion in fixed income, with possibly some volatility management mechanism used in the portfolio as well. You still have a journey from 80 per cent plus in equities when you’re in your 20s to 40 per cent in equities when you’re in your 60s and beyond. The path is still valid – it’s just at the end point it should have a higher rating in equities that are more consistent with the allocations you might see in an ARF. Target date funds are a good means of delivering that.”