‘In the olden days’, the general advice regarding a pension fund was to begin reducing the equity proportion of your investment fund as you approached retirement.
The reason for this was twofold: equities carried a higher risk than bonds and property; almost all retirees bought an annuity which was then a ‘locked-in’ income.
I’ll cover these and why they are important.
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Most pension funds have a full spread of bonds, property and international equities, and this is ‘managed’ by the fund manager. I say ‘managed’ because many funds are not managed at all, but you are still charged. You may remember the column I did last year showing how £100,000 invested into the best pension fund returned over £1m over 20 years, whereas the worst returned just £95,000. Please don’t be apathetic about that boring pension document in your cupboard that you find as interesting as a politician telling a joke. £900,000 is a hefty price to pay for apathy - £300,000 per syllable. Ask an independent financial adviser to have a look at the funds that you are invested into, and see if there is a more appropriate fund available where you are getting what you paid for.
Spreading across bonds, property and international equities is how risk is balanced out. In normal markets, they are negatively correlated, i.e. they behave differently, so while one might take a downturn, that same market condition supports the others values upwards.
And so, as you approach retirement, it’s easy to see why reducing the potential for downward fluctuation is important, as the potential for fluctuation is the biggest risk as you mightn’t have time to recover - a 10-20 per cent drop in an equity isn’t ideal as you move that close to retirement.
The real risk issue was because of the need to buy the annuity straight away at retirement date but that went out with pet rocks (google that).
With an annuity, you use your fund to buy a guaranteed income for a certain period so the value of the fund at retirement was everything. If the fund in the five years leading up to retirement had fallen by, say 15 per cent, you would then be buying an income that is 15 per cent lower for life - a hard carrot to swallow.
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Most people haven’t been buying annuities because of the benefits of drawdown, but also poor annuity rates due to the previous lower interest environment, which has of course changed over the last few months.
With drawdown, you are not forced to buy an annuity, instead you leave your capital invested and take withdrawals at a set amount and allow the capital to grow. It also has excellent Inheritance Tax benefits. This pushes out the need to buy an annuity, and therefore the need to reduce equity holdings running up to normal retirement is negated i.e. a fluctuation downward doesn’t mean you are crystalising that loss by buying a lower annuity that you are stuck with for your retirement. Happy days.
And so I come to so called ‘targeted funds’ or ‘target retirement strategies’. These funds are typically marketed to financial advisers as haven strategies to manage their customers’ money. They go something like this: At a predefined date, your money is moved gradually out of equities and into less volatile (prices don’t move around as much) holdings (ie cash, bonds etc). Therein lies the issue. There are definitely market conditions that favour buying international equities, bonds or even property. Often there can be sharp movements which create buying or even selling opportunities.
These can become obvious at the time, but a predefined strategy fund could mean you will buy something you really should be selling, and vice versa. Moreover, as you don’t actually need to buy an annuity at normal retirement date, moving out of equities when you don’t need to isn’t where your growth will come from. I do accept it brings the fluctuation down, but without the need to buy the annuity, the fluctuation matters less so.
If you have a good adviser, they can create that strategy by lowering risk levels at the point when it is needed, which could be years later or earlier.
I accept that the fund manager will disagree with me because locking into a five-year target exit fund means they have that money guaranteed in their coffers alongside the nice fees that go with it. Don’t worry about them, they’ll survive without your money.
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- Peter McGahan is the Chief Executive Officer of Independent Financial Adviser Worldwide Financial Planning. Worldwide Financial Planning is authorised and regulated by the Financial Conduct Authority.