Tom Selby analyses whether a portfolio based on market conditions would be more suitable for today’s client
What is the best way to invest for retirement? This seemingly simple question has spawned myriad theories and investment strategies designed to give savers the biggest bang for their pension buck.
One of the central tenets of retirement planning theory has been lifestyling – an investment strategy whereby a saver’s asset allocation is automatically shifted away from higher risk investments towards bonds and cash as they approach a set retirement date.
The logic of this approach is that, as someone gets closer to the point at which they want to take an income from their retirement pot, their capacity for loss reduces.
However, lifestyling is based on a world where the majority turn their defined contribution savings into a guaranteed income stream by buying an annuity.
Following the introduction of pension freedom, this approach has changed with the vast majority now remaining invested through drawdown, with sales outstripping annuities by roughly two to one.
The ‘old’ world
Before consigning lifestyling to the retirement Room 101, it is worth noting that about 80,000 annuities are still sold by the insurance industry each year.
Many of these people will not be engaged, have little (if any) capacity for loss and value the security of a guaranteed income. In such circumstances, lifestyling might well provide adequate protection against the downside risk associated with stock market investing.
But whether this approach is appropriate for the majority is now open to serious challenge. A recent paper published by 7IM argues that investment risk is often given too much weighting versus other retirement risks, such as savings risk, longevity risk, inflation risk and event risk (such as divorce or illness).
Rising equity
7IM points to academic research by John Spitzer and Sandeep Singh, both professors at the State University of New York.
The pair analysed lifestyle strategies over a 30-year period and found that withdrawing from bonds first – so increasing equity exposure as clients get older – was the best performing strategy of all.
The authors acknowledged this “rising equity” approach would likely make some investors uneasy. You can say that again – any adviser who had told clients approaching retirement to load up on UK and US equities in 2007 would have faced some seriously awkward questions.
To dismiss this research would be remiss, however. Potentially significant sections of advised clients could have the capacity to take more investment risk than traditional lifestyling theory suggests both up to and beyond their retirement date.
Furthermore, the return of inflation to the UK economy could push more people to take extra investment risk later in their lives just to preserve their spending power in retirement.
But sequence risk – that is the difficulty in making up for poor returns in the early years of retirement – means many advisers and clients will understandably be nervous about abandoning derisking strategies altogether.
Dynamic lifestyling
Growing questions about the rigid nature of traditional lifestyling strategies across the Atlantic has seen so-called “dynamic” lifestyling investment solutions come to the fore.
Unlike traditional lifestyling, where asset allocation changes are often pre-determined, dynamic lifestyling allows the portfolio mix to shift depending on the prevailing market conditions.
There are broadly two types of dynamic lifestyle strategies. Under the first, a portion of the client’s portfolio – say, 20% – is invested in a dynamic fund which makes unconstrained asset allocation decisions. The remaining 80% would go into a traditional, deterministic lifestyle fund.
The second version is 100% dynamic, but within certain set parameters. So if, for example, the deterministic lifestyle strategy puts the emerging equities allocation at 6%, the dynamic lifestyle strategy could have the flexibility to alter this to anywhere from 3% to 9%.
GMO, the global investment consultancy, argues such strategies – which use set valuation metrics to alter allocations at different points in time – would have delivered better risk-adjusted returns between 1975 and 2015.
If similar solutions gain traction on these shores, the reign of traditional lifestyle strategies may come under serious threat.
Tom Selby is senior analyst at AJ Bell
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