Cutting investment risk could leave pensioners stuck for cash later on, experts warn
- Millions of people in lifestyle funds face running out of cash in retirement - 7IM
- Taking on greater investment risk works best with large pension pots
- Savers should prepare for the prospect of funding care cost in later life
For years, the process of shedding your nest egg of riskier assets and replacing them with supposed sure bets as retirement edges closer has become the default approach for savers.
But new research from Seven Investment Management (7IM), found the strategy of reducing investment risk as retirement approaches may result in millions of people running out of cash towards the end of their lives.
This strategy, called lifestyling, is typically adopted by workplace pension providers and is geared towards converting pension savings into an annuity which offers regular income that lasts as long as you do.
Consumer group Which? estimates that £100billion of pension savings are investing in these funds.
However, savers are no longer restricted to buying an annuity at retirement thanks to the advent pension freedoms in what was the biggest shake up in retirement rules for a century.
Pensioners can now use the full amount of their pot however they wish, with many advisers suggesting that they keep it invested it and draw on it to provide their retirement income.
Those who intend to take full advantage of the new freedoms and shun the traditional retirement income solution of an annuity now face the tricky task of ensuring that the funds they have accumulated all these years will last them until they die.
What is more, firms in the public and private sector seldom offer defined benefit pension schemes anymore - where they promise to pay an annual income in retirement - because many existing schemes are in deficit.
Pensions consultancy firm JLT Employee Benefits, reported a £182bn blackhole in the UK private sector pension schemes alone.
Many companies now favour defined contribution schemes in which an individual, or employer and employee, agree on a set amount to be paid regularly into an individual retirement pot.
Chris Darbyshire, chief investment officer at 7IM and co-author of the research said: 'The world has changed. With a huge number of default pension funds automatically reducing risk as retirement approaches, many investors are sleepwalking into an uncertain retirement.
'We are not saying reducing risk isn't right for some people, but this is a conversation that needs to be happening. Investors should not underestimate the power of compounding. By reducing investment risk at the point when you are at your wealthiest you reduce its enormous potential benefits.'
The risks your pension pot faces
Speaking at the report launch event, Matthew Yeates, quantitative investment manager at 7IM, said that there five main risks that could stop savers from reaching their financial goals.
These are the risk of losing capital when investing, not saving enough, outliving these savings, the risk of prices rising faster than the value of the savings and the risk of a financial plan being spoiled by unexpected events such as divorce and illness.
7IM's research modelled returns for two investors who each saved an average of around £7,500 a year from the age of 30 to 60 and retired with a pension tat could provide an annual income of £22,000 a year.
One saver invested in a moderately cautious portfolio targeting a return of 4 per cent a year; the other took a step up the risk ladder, investing in a balanced portfolio targeting a return of 5 per cent a year.
At retirement the first had a portfolio worth around £375,000 and the second had £425,000.
The first ran out of money at 86, having withdrawn £22,000 per year, while the balanced investor still had around £275,000 left at this point - showing the impact a small hike in risk can have on a portfolio according to the fund house.
In addition, 7IM also ran the portfolios through a range of outcomes drawing on the historic volatility experience in a 12 year period to January 2016.
This period includes the global financial crisis and the eurozone crisis.
Here, the moderately cautious investor ran out of money at 79. The balanced investor’s money lasted another four years – to 83.
Mr Yeates said: 'Risks are tools and levers that investors can pull over time to maximise the chance of reaching their retirement funding goal balancing that risk to get to that point.'
'When your pot is small, saving a percentage of your salary is going to have an impact on the size of your pension pot. As you get older and as your pension pot grows larger relative to your salary - that investment lever becomes more powerful.'
The need to bolster the income potential of retirement savings is compounded by the fact that we are all living longer.
According to a study by think tank the Resolution Foundation, those born a century ago were expected to live to 63 on average, whereas for the generation born in the last 15 years life expectancy at birth is 93 - with over a third of the generation after expected to reach age 100.
Raising funding for care cost in latter life has come to the fore amid the battle for number 10 with each major political party committing to tackling the issue in some way shape or form in their respective manifestos.
Should you change your retirement plan?
Lifestyling has become a staple retirement strategy but it was devised in a environment where the main retirement income solution available to savers was an annuity.
The world is a different place now and uncertainty over the government's role in funding care in later life means that people should save for the possibility of footing the cost themselves.
The idea of switching into less riskier assets typically cash and bonds as you approach retirement might sound like a good idea -and in some cases it is. However, these safer assets are not yielding very much at this moment in time. Bond yields, for example, have been fledgling in times of late - particularly following the UK vote to leave the EU. However, savers should always be aware that things change over time.
In saying this, if you can afford not to take risks with your nest egg, then don't.
Saver are strongly encouraged to seek professional financial advise before tweaking their plans.
It is worth noting that the government has a free and impartial service which offers guidance on pension matters.
What about the state pension?
As well as private pension, taxpayers will have access to a state pension once they reach the seemingly ever increasing retirement savings threshold.
However, pension liabilities are probably the biggest fiscal problem facing governments not only in the UK but worldwide today. Therefore, it is ill advised for savers to hedge their bets on their state pension to allay potential income shortfall at retirement.
Domestically, the Conservative Party, which is widely tipped to achieve a majority government in the upcoming elections, said it will axe the triple lock to reduce the state pension cost burden to the government if Theresa May wins the general election.
The party said it would switch to 'double lock' increases in three years' time, so the state pension would no longer rise by a minimum of 2.5 per cent each year, but by whichever is the highest of inflation or annual earnings growth.
Also speaking at the launch event, Justin Urquhart Stewart, co-founder and head of corporate development said: 'Government is increasingly unable to afford a number of public sector services be it healthcare or pensions.
'We need to educate people to the idea that irrespective of your political colour, you are going to have to assume that support from the state is going to be reducing.'
'Let that be a kick to people to start having more awareness of what their position is and then be able to ask questions from providers and experts and ask what do I have to do to fix this.'
What do advisers say?
Speaking at the event, Pete Matthew, chartered financial planner, at Jacksons Wealth Management said: 'Lifestyling has become the norm because it is a very easy sell from the provider and adviser as well. This is a fire and forget solution.'
'Risk is a lever. it is something that is not to be afraid of but something to wield and harness in the pursuit of financial security but we (the industry) do not teach that. Risk is the right word to use but it is laden with negative connotations and that is what we have to educate out of people.'
Ben Yearsley, director of Shore Financial Planning said: 'Reducing risk and changing your asset allocation progressively from equities to bonds on the approach to retirement was sensible when most people bought annuities. However, with that need now gone for many and retirement maybe stretching 30 years or more the approach to your investments post retirement is now markedly different.
'In my view, most investors need to stay invested in real assets, i.e. predominantly equities for much longer than in the past to ensure their capital and ultimately their income keeps pace with inflation as a bare minimum. Most underestimate how much money they will need in retirement.'
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