Wealthier employees are being shoehorned into unsuitable pension arrangements that expose them to too much risk when they are young, but invest much too cautiously as they hit retirement.
That is the finding of a report from Cass Business School in London, which examined the strategies adopted by typical defined purchase pension schemes across Britain.
The report, Optimal Funding and Investment Strategies in Pension Plans, by Professor David Blake, concludes that the one-size-fits-all nature of default funds in workplace money purchase schemes means millions of higher-rate taxpayers are investing in the wrong types of assets throughout their lives.
For Prof Blake, the problem centres on the fact that default funds assume that everyone in them is going to use all their pot to buy an annuity on the day they retire. While this may be the right solution for the majority of people, who cannot afford the risk or advice costs of income drawdown, for a substantial minority a 100pc switch out of equities is unsuitable.
Research from the Pensions Policy Institute shows that 25pc of defined contribution pension savers over 55 have sufficient assets to consider income drawdown, yet anyone planning to do so should not be entirely invested in bonds.
Existing default funds are not just unsuitable for wealthier pension investors, but they expose people of all income groups to too much risk in their late forties and fifties, says the report.
Prof Blake said: “The problem with default funds is they start switching people out of equities too late, but, when they finally do so, it happens too fast and it goes too far.”
With money purchase pension schemes, it is the individual who is exposed to stock market risk. To avoid the risk that a 30pc drop in the stock market the day before you retire translates to a 30pc drop in pension income, as happened to some individuals in 2008, most pension funds operate an automatic de-risking system. This gradually switches tranches of your fund out of equities and into bonds, gilts or cash. This process, called “lifestyling”, usually happens in the five or 10 years preceding your stated retirement date.
Prof Blake’s research concludes that the switch away from risky assets should start much sooner, gradually moving investors out of equities when they are in their late forties. But rather than reaching retirement age 100pc invested in bonds, wealthier people should still have between 20pc and 50pc left in equities.
Andy Cheseldine, of pension consultancy LCP, said: “Lifestyling only works for the 80pc of people who are going to end up buying an annuity. It is a very blunt instrument and if you know that you will not be buying an annuity when you retire with the whole of your fund, then you should not be 100pc in bonds or gilts when you reach retirement age.”
Investment experts agree that equities are absolutely the right asset class for younger investors because they have historically returned more on average than bonds for longer periods. But over shorter time investment horizons the chances of them outperforming fall.
The Barclays Equity/Gilt study has been collecting data on the relative performance of different asset classes since 1899. Of the 94 discrete 18-year periods since the end of the 19th century, equities outperformed cash for 93 of them and beat gilts on 83 occasions.
But consider a 10-year time horizon and you don’t have to look far to find cash and gilts outperforming equities. In the so called “lost decade for equities”, the 10 years to 2010, UK equities generated on average a return of 0.6pc a year, compared with 2.4pc for gilts and 1.1pc for cash.
Prof Blake argued that while equities were expected to outperform, the risk they will not do so grows as the investment horizon shortens. For this reason investors need to start moving at least some of their assets into bonds in their mid to late forties.
“Depending on how risk averse you are, you should have between 20pc and 50pc of your fund in equities on the day you retire,” he said. “This is because you are going to live for possibly another 30 years, so want to attempt to achieve some of the higher potential returns available from equities.”
Rather than plain vanilla equity funds, Prof Blake preferred diversified growth funds that offer access to a range of growth asset classes such as property, currency, infrastructure, private equity and debt as well as traditional equities, which are designed to give equity-like performance but with lower volatility.
Once in income drawdown, investors should continue the strategy of taking risk out of their portfolio gradually.
This is because the nearer you approach your likely age of death, the better rate of return you get from an annuity, making annuities increasingly attractive compared with income drawdown . This effect, known as “mortality drag”, means your investments have to return around 6pc a year by age 75 for your drawdown pot to keep pace with what an annuity would pay you. By age 80 the figure is a difficult-to-achieve 7.4pc.
Most experts agree that this strategy is pretty close to the sort of solution that wealthy people paying for professional advice would receive.
Andrew Herberts, investment director at Adam Investment Management, said: “Dr Blake’s approach more or less describes what we do for our clients at the moment.”
Another advantage of phasing annuity purchase in this way is that it reduces the risk of buying one at the bottom of the market. “Making a once-in-a-lifetime switch into an annuity at age 65 is not optimal because you could be at the bottom of the interest-rate cycle,” said Prof Blake. “Phasing your annuity purchase hedges you against that interest-rate risk.”
Billy Burrows, a director of Better Retirement Group, said: “If you want to phase your annuity purchase, there are two ways to do it. If you already have several pension policies, you can use them to buy annuities one at a time.
“Alternatively, you can put your entire fund into a low-cost Sipp and take chunks out as and when you want to. Another advantage of waiting is that the older you get, the more chance you can get an enhanced annuity on grounds of ill health.
“And you will find it easier to pass on the assets still in your Sipp in the event that you die. But you will face a cost each time you transfer money from your Sipp, as well as the cost of advice on your annuity purchase.”
Defined contribution pensions are risky enough as it is – so it is worth making sure you are taking risks only when it is in your interests to do so.
Prof Blake said: “The problem with default funds is they start switching people out of equities too late, but, when they finally do so, it happens too fast and it goes too far.”
With money purchase pension schemes, it is the individual who is exposed to stock market risk. To avoid the risk that a 30pc drop in the stock market the day before you retire translates to a 30pc drop in pension income, as happened to some individuals in 2008, most pension funds operate an automatic de-risking system. This gradually switches tranches of your fund out of equities and into bonds, gilts or cash. This process, called “lifestyling”, usually happens in the five or 10 years preceding your stated retirement date.
Prof Blake’s research concludes that the switch away from risky assets should start much sooner, gradually moving investors out of equities when they are in their late forties. But rather than reaching retirement age 100pc invested in bonds, wealthier people should still have between 20pc and 50pc left in equities.
Andy Cheseldine, of pension consultancy LCP, said: “Lifestyling only works for the 80pc of people who are going to end up buying an annuity. It is a very blunt instrument and if you know that you will not be buying an annuity when you retire with the whole of your fund, then you should not be 100pc in bonds or gilts when you reach retirement age.”
Beware the default fund
Default funds have stayed in the thrall of the cult of equities long after years of good performance stopped masking poor asset allocation.Investment experts agree that equities are absolutely the right asset class for younger investors because they have historically returned more on average than bonds for longer periods. But over shorter time investment horizons the chances of them outperforming fall.
The Barclays Equity/Gilt study has been collecting data on the relative performance of different asset classes since 1899. Of the 94 discrete 18-year periods since the end of the 19th century, equities outperformed cash for 93 of them and beat gilts on 83 occasions.
But consider a 10-year time horizon and you don’t have to look far to find cash and gilts outperforming equities. In the so called “lost decade for equities”, the 10 years to 2010, UK equities generated on average a return of 0.6pc a year, compared with 2.4pc for gilts and 1.1pc for cash.
Prof Blake argued that while equities were expected to outperform, the risk they will not do so grows as the investment horizon shortens. For this reason investors need to start moving at least some of their assets into bonds in their mid to late forties.
“Depending on how risk averse you are, you should have between 20pc and 50pc of your fund in equities on the day you retire,” he said. “This is because you are going to live for possibly another 30 years, so want to attempt to achieve some of the higher potential returns available from equities.”
Rather than plain vanilla equity funds, Prof Blake preferred diversified growth funds that offer access to a range of growth asset classes such as property, currency, infrastructure, private equity and debt as well as traditional equities, which are designed to give equity-like performance but with lower volatility.
Once in income drawdown, investors should continue the strategy of taking risk out of their portfolio gradually.
This is because the nearer you approach your likely age of death, the better rate of return you get from an annuity, making annuities increasingly attractive compared with income drawdown . This effect, known as “mortality drag”, means your investments have to return around 6pc a year by age 75 for your drawdown pot to keep pace with what an annuity would pay you. By age 80 the figure is a difficult-to-achieve 7.4pc.
Most experts agree that this strategy is pretty close to the sort of solution that wealthy people paying for professional advice would receive.
Andrew Herberts, investment director at Adam Investment Management, said: “Dr Blake’s approach more or less describes what we do for our clients at the moment.”
Another advantage of phasing annuity purchase in this way is that it reduces the risk of buying one at the bottom of the market. “Making a once-in-a-lifetime switch into an annuity at age 65 is not optimal because you could be at the bottom of the interest-rate cycle,” said Prof Blake. “Phasing your annuity purchase hedges you against that interest-rate risk.”
Billy Burrows, a director of Better Retirement Group, said: “If you want to phase your annuity purchase, there are two ways to do it. If you already have several pension policies, you can use them to buy annuities one at a time.
“Alternatively, you can put your entire fund into a low-cost Sipp and take chunks out as and when you want to. Another advantage of waiting is that the older you get, the more chance you can get an enhanced annuity on grounds of ill health.
“And you will find it easier to pass on the assets still in your Sipp in the event that you die. But you will face a cost each time you transfer money from your Sipp, as well as the cost of advice on your annuity purchase.”
Defined contribution pensions are risky enough as it is – so it is worth making sure you are taking risks only when it is in your interests to do so.
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