Deciding how to invest your pension savings can be a pretty onerous task. There’s a lot of technical detail to grasp and a good number of decisions to make. Once you’ve made those decisions it’s tempting to sit back, put the matter to the back of your mind and consider the job done. But taking a fit and forget approach to your asset allocation strategy can dangerous.
Allocation of funds amongst different asset classes needs to change as you get older and failing to make the necessary adjustments could result in your retirement income being decimated at the 11th hour as markets rise and fall.
Here’s how your portfolio structure needs to change as you get older to avoid this happening.
It’s a matter of risk
The primary reason for adjusting your portfolio mix over time is to protect your investments from losses that cannot be recovered before you need to make a withdrawal from your fund. It’s about managing risk.
Were you happy making risky investments in your 20s or 30s, when the numbers were small and retirement was a long way off? Probably, Yes. Would you be happy to place your entire accumulated pension fund in a high risk venture 12 months out from retirement? I doubt so.
Quite right. You’d be crazy to risk your retirement income in such a dramatic way so close to retirement.
It’s common sense really. Good portfolio management requires you to make small, regular adjustments to your portfolio mix so that your risk exposure gradually reduces over time.
So where does risk come from and what does that mean for your portfolio?
There are many different types of risk. Vanguard summarises these neatly.
That’s a long list and managing each of these exposures is a big ask for anyone not doing it as their day job. Fortunately you only need to really worry about one of these when thinking about how to adapt your portfolio mix over time. And that’s volatility.
Reducing Volatility as You near Retirement
The market value of your investments will rise and fall as you save towards your retirement. That doesn’t matter so much – providing you reach your investment goal in the end. You see the peaks and troughs of the market eventually smooth out over time. Growing your retirement portfolio will never be a smooth journey.
What does matter though is if there is a fall in market prices just before you want to take a big chunk of income from your fund. Doing so could cause real damage to your future income potential because you will be forced crystallise your paper losses when making a withdrawal.
Reducing the volatility of your portfolio as you approach retirement, lessens the likelihood that you’ll have a big fall in your fund value when you can least afford it.
Prices can be a roller-coaster ride in the short-term, however in the long-term, markets tend provide returns in balance with the risks.
Michael S Nemick
Let’s look at what this means on the ground. Your pension fund will probably be invested in different asset classes. There are four to choose from: Property, Equities, Bonds and Cash. Each of these different asset classes carries different levels of volatility risk. Property is the most volatile, followed by equities, bonds and then cash (which is subject really only to inflation risk).
Holding all your portfolio in property close to retirement could mean you having to choose between living on a fraction of your target retirement income or delaying retirement by many years. That’s if things went horribly wrong and the market crashed just as you retired; certainly not a nice choice to make.
So why not avoid volatility risk altogether and hold cash throughout the accumulation phase of your pension? That’s the safest bet, surely? Well, Yes. But risk is only one side of the coin. The other side is performance.
Investments with the lowest risk also have the lowest performance. It’s simply not possible to have your cake and eat it where risk is concerned. You’re unlikely to reach your retirement goals by investing in cash alone.
Trading Off Risk and Performance
Investment performance and risk go hand in hand. You can’t have one without the other; it’s as simple as that. If you want the highest returns, you’ll need to accept those will come with increased risk.
The reason why higher risk investments carry higher returns can be put down to straightforward market pricing. If a high risk investment didn’t offer superior returns, no one would place their money in that investment. Why would they do so without any reward?
The illustration below demonstrates how the building blocks of your investment portfolio fit together.
Creating a balanced portfolio therefore is about assigning a weighting for each of the four building blocks so that, in the round, you are happy with the trade off you’ve made between risk and reward. Your portfolio needs to provide high enough returns that you can meet your target fund value whilst not creating a substantial risk of you failing to meet that target.
Rebalancing your portfolio over time, simply means moving the slider to the left every few years, out of the higher risk asset classes (property and equities) and into lower risk classes (bonds and cash).
Lifestage (or Target Date) Funds
To help the people manage this transition to a lower risk investment portfolio, pension providers developed the “Lifestage Fund”. The key selling point of this type of product is that the asset allocation strategy (such as equities and bonds) of your fund is adjusted automatically over time by the provider to become more conservative as retirement nears. Put simply, they do the rebalancing for you.
There a number of different rule sets that are used to drive these changes. The more common ones used by providers are:
100 Minus Age. The percentage of your fund invested in equities is calculated by a simple formula of 100 minus your age. So, at age 40 you’d have 60% of your pension fund invested in equities. And by age 60, only 40% of the fund would be in equities. Everything else would be in bonds.
Matrix Approach. Probably the most widely used, this approach reduces the number of adjustments to four but introduces a different approach in accumulation and distribution phases.
Following this approach, someone in their early 30s just starting out in their career should have a mix heavily weighted towards equities. Nearing retirement the share allocated to equities should be reduced to 60% and then further to 50% during retirement.
The Problem with Using a Lifestage Approach
Whilst the lifestage approach to determining portfolio mix simplifies your decision making process, the problem is that it is over-simplistic and doesn’t reflect the intricacies of many people’s lives.
If all you are saving up for is a basic retirement income the lifestage approach is fine. However, it’s not fine if you want to also have money available for a house refurbishment, to pay off the kids’ university fees, help buy them a house or create a nice inheritance.
Firstly you may need to access your money for these purposes at different times. Essentially you have not one investment fund, but many; some of which you’ll need to access earlier than others. So given that the investment horizon for each of these “mini funds” is different, it follows that the level of risk carried in each should also be different.
Secondly, you may also have a different attitude to risk for each purpose. The consequences of not being able to pay your household bills in retirement are dire and you’ll probably want to adopt a relatively conservative investment approach when saving for this purpose. However, you might view that buying a house for the kids is a “nice to have” and, whilst you’d be disappointed, you could live with not achieving this investment objective. A more aggressive investment approach could be more relevant when saving for this purpose.
Lifestage funds do not take these differing timings or attitudes to risk into account. Nor do they generally account for alternative investments that you may have, e.g. company ownership or rental properties.
Building a Tailored Investment Portfolio
The answer then is to plan for each of these separate pots in turn and then update the risk profile on each as the investment horizon on the pot get’s nearer over time. There’s a simple four-step process that you can follow:
Step 1: Identify your future financial needs. Conceptualise a number of different pots, think about how big each needs to be and when you want to access your investment.
Step 2: Pick your spot on risk/return line for each pot. Consider your attitude to risk in relation to each fund.
Step 3: Create balanced portfolio mix for each pot. Ensure these reflect your attitude to risk for each respective investment purpose and the time horizon for your investment.
Step 4: Update your portfolio mix regularly as you get closer to withdrawal. Ensure that any changes in market conditions, your circumstances and investment horizons are reflected in your asset allocation strategy.
Tools and Resources to Help Your Planning
Independent Financial Advisers have access to a range of tools that can be used to help with this planning which include:
- Montecarlo simulation (for forecasting future fund values)
- Attitude to risk profiling questionnaire
- Fund research
You may find that levering an IFA’s access to these tools, together with their knowledge and experience can help you build a robust investment strategy more quickly and easily.
It’s vital to ensure that you adjust your investment strategy over time. Doing so will allow you to reduce the risk of your portfolio’s value falling just before you need to make a withdrawal from your fund. Identify different investment objectives and build a separate strategy for each objective so that you can adequately reflect your investment horizon and attitude to risk for each.