Lifestyling investments questioned as retirement choices change

Life used to be so simple. Members of defined-contribution (DC) pension schemes had one option on retirement after taking their tax-free lump sum – they invested their pension pot in an annuity, an insurance product which guarantees an income for as long as you live.

In those circumstances, it made a lot of sense to reduce the investment risk profile of your pension fund the closer you came to retirement. The logic being that you had less chance of recovering from a short-term market shock as you approached retirement. The strategy adopted, known as lifestyling, saw the investment balance in the fund shift over time from risk assets such as equities to low- or no-risk assets such as cash or bonds.

In effect, it inoculated people from the effects of a stock-market crash on the eve of their retirement.

But things have changed and become more complex since then. Many DC members now opt to invest their pension pot in what is known as an approved retirement fund (ARF). First introduced in the late 1990s by the then minister for finance Charlie McCreevy, an ARF is an investment fund containing a portfolio of assets including equities and bonds and the pension is paid out of the returns it achieves.

The case for lifestyling is harder to make if people are going to invest in an ARF anyway. Why sell out of equities if you’re just going to pile back into them the day you retire?

"One criticism of traditional lifestyling strategies is they have not evolved to recognise the wider set of post-retirement options now available," says Irish Life head of products Shane O'Farrell. "A better form of strategy allows the person choose which option they want.

“The most sophisticated goes further and uses past outcomes for that type of person to forecast which option they are most likely to choose based on their fund size, earnings and so on and directs their pre-retirement de-risking phase into the right bucket automatically: either bonds for the annuity person or a balanced portfolio for the ARF person.”

Adjusted strategies

Caitriona MacGuinness, DC and master trust leader with Mercer Ireland, argues that strategies should be adjusted to meet the particular circumstances of schemes. "A lifestyle strategy for any company pension plan should consider the specific membership of the plan.

For plans with high contributions and high retirement savings, targeting an ARF end point in the default strategy may be the appropriate option. However, for many plans, the majority of members may be in the category where annuity and cash is a more likely outcome and hence targeting this mix in the default remains appropriate.

While setting the appropriate default is a key responsibility of trustees, it is generally advisable to provide members with a choice of lifestyle strategies, catering for those for whom the default may not be appropriate. The key is that the trustees of each scheme should understand their specific membership, put in place the appropriate default and range of lifestyle strategies and communicate clearly with their members particularly as they approach to retirement.”

Risk averse

Investment has to be viewed as a continuum, says Declan Maher, head of corporate pension and risk sales with Bank of Ireland Wealth Advice & Distribution. "Many commentators, who are advocates of long-term investing, would suggest that a pension saver at age 60, for example, intending to retire at 65, isn't investing for five years, but is in fact investing for a period of 25 years or more.

“The basis of this investment term, it is argued, is determined not by the clients’ age to retirement, but on the basis of the clients’ life expectancy. We know that people are generally living longer lives, so this should be factored in when planning for your future investment needs.”

However, this should not mean that people continue to take the same level of risk. “We know that most investors are risk averse,” he says. “We know that when we do take risk we feel the pain of loss roughly twice as much as the pleasure of the equivalent gain.

Behaviourally, we also know that the average investor will break their pre and post retirement into two separate journeys. For the vast majority of pension savers, reducing exposure to risk assets as we come closer to retirement makes sense, and lifestyling investing as a strategy does work.”