What are the various scenarios and possible options for self-invested personal pension investors as retirement nears?
Wobbly markets may have given those contemplating retirement pause for thought. In recent years, managing a retirement portfolio has been like falling off a log: as long as the portfolio is invested in financial markets rather than cash, it’s been going up. However, recent volatility suggests this ‘in it to win it’ approach may not be as effective in future.
While this is worrying in the shorter term, preparation for retirement should be a multi-year process. If you are on the cusp of retirement and panicking that your self-invested pension portfolio (Sipp) has dropped in the recent rout, you may have to rethink. Sipp investors should start thinking about retirement three to five years ahead – those who don’t are vulnerable to drops in the market just prior to retirement, leaving them with less money to generate an income: the phenomenon of ‘pound cost ravaging’.
Andy Parsons, head of investments at the Share Centre, says: “If you are 10-15 years from retirement, you can afford to have a higher weighting to the stockmarket. On a three to five-year horizon, you should be reducing your exposure. This can take a number of forms – taking down mid and small-cap exposure and moving into larger capitalisation defensive companies, buying bonds and holding a higher weighting in cash. It is important to keep your pension at as high a value as possible.”
As long as you have been planning ahead, the recent market blip shouldn’t trouble you too much. However, it is an urgent reminder of the need to prepare. The form that this will take depends on how you plan to create an income.
Annuities are no longer the default option for those entering retirement, but for many they remain the only way to secure a guaranteed income in retirement. The path to an annuity purchase is well-trodden. Investors typically shift their asset allocation progressively away from the stockmarket and towards bonds, to reduce the risk of losing money just before they buy the annuity.
Annuity rates are linked to the current rate paid by government bonds. As it stands, this is pretty unexciting at 1.28% and lags inflation, but moving slowly into government bonds over time removes the risk of being hit by major fluctuations in either the bond markets or the stockmarkets. If you’re planning to buy an annuity, this shift in to bonds should happen regardless of the current level of markets; most important is to do it gradually, which mitigates against market shocks.
It may be that you only want to buy a partial annuity, in which case, you should only move a segment of your portfolio.
Prepare your portfolio
Ben Willis, head of portfolio management at Chase de Vere, makes the follow fund suggestions for someone who is moving into government bonds ahead of an annuity purchase:
• iShares Overseas Government Bond Index
• L&G Short Dated Sterling Corporate Bond Index
• Vontobel TwentyFour Absolute Return Credit
Robert Gout, chartered independent wealth planner at WH Ireland, says that falling annuity rates, the introduction of pension freedoms and improved pension death benefits have all encouraged people to consider drawdown rather than annuities as a way to generate their retirement income.
The problem is that this means the risk of not having enough income is passed to the individual, which makes them more dependent on the stockmarket and therefore more vulnerable to market fluctuations. It is a classic Catch 22 – investors have to retain exposure to stockmarkets to ensure their investment returns beat inflation, but then they have to take the highs and lows of the market.
Gout says: “Strong investment markets over recent years have meant that investors have been rewarded for the risks taken, and have seen their pension fund grow even after drawing on it to meet their income needs. However, the recent stockmarket downturn towards the end of last year will have been the first test for many people of whether they have adopted a suitable strategy to fund their lifestyle in retirement.”
It’s a balancing act and financial planners are divided over the best option. Some argue that all income needs to be ‘organic’ – generated in full by the dividends on shares or interest on bonds. Otherwise there is the risk of eroding your capital base, which in turn reduces the amount of income that can be generated in future. See box for more about this danger and how to mitigate it.
Others believe that focusing solely on income assets means some investors neglect the capital growth element of their portfolio. Certainly, at a time when lower interest rates have prompted a ‘scramble for income’, some income assets may be expensive and offer little room for growth. Incorporating some growth-focused assets – smaller companies or emerging markets – can mitigate this problem.
Gout says: “Your pension fund will need to provide you with an income for the rest of your life, and so you could be looking at funds being invested for more than 30 years. It is therefore important to take a long-term view and invest in assets that will at least keep pace with inflation and support future income payments.” That mean retaining some weighting in ‘risk’ assets such as the stockmarket and avoiding a very low-risk portfolio focused on government bonds and cash.
Nevertheless, it is better to err on the defensive side for a drawdown portfolio. Big losses can permanently dent the income potential of a portfolio. As such, if there are a few residual high-risk investments in the portfolio – that Vietnamese smaller companies fund, for example – it may be worth paring them back to something a little steadier.
Prepare your portfolio
Ben Willis of Chase de Vere makes the following fund suggestions for someone who is looking for a solid income-generative balanced fund for a drawdown portfolio:
• Artemis Monthly Distribution
• Invesco Distribution
• Premier Multi-Asset Distribution
There will be some lucky investors who can invest more flexibly. That may apply to you if you have an alternative income source. You may still be working, or hold a decent final salary company pension that provides you with sufficient income to live; or you might have buy-to-let income, or an Isa. Either way, this means you can take a bit more risk with the holdings in your Sipp portfolio and, in the context of the current wobble, that you can afford to ride out the volatility.
There are certain advantages to not using your pension as the main source of income in retirement. For example, it falls out of your estate for inheritance tax purposes, so it can be tax-efficient to preserve as much of the pension pot as possible. Additionally, income generated from investments held in an Isa or venture capital trust are not taxable, but pension income (apart from the 25% tax-free allowance) is taxable. It may therefore be feasible to take that tax-free income while remaining in a lower tax bracket.
In this instance, investors have the scope to be a little more creative. Paul Latham, managing director at Octopus Investments, says he finds more and more clients keen to direct their wealth to areas that mean something to them, rather than simply financial assets. “Even if you are past retirement, you may have 20-30 years to live. This is long-term patient capital and there are more interesting things to do with it than leave it in an exchange traded fund tracker or a portfolio of bonds.”
He adds: “People care about the returns they get from a tracker, but they don’t care about what the money is being used for… Increasingly they want their money to make a difference – whether that is supporting the economy through smaller companies or supporting the environment. Many will want to invest in companies that may employ their grandchildren.” He believes retirees need to think more broadly about where and how they are investing.
There is increasing scope for them to do this. Mainstream fund groups now have ‘Impact’, ESG’ or ‘Sustainability’ funds. M&G, for example, recently launched a Positive Impact fund, while Investec has launched its smaller companies-focused UK Sustainable Equity fund. Aim stocks may also be an option for a small part of a portfolio. These also have inheritance tax advantages if they are held in the right way, and a number of providers now have Aim portfolios designed with this in mind.
One final option for wannabe retirees looking uncomfortably at tricky markets is simply to delay. Certainly, delaying taking benefits can increase the size of your pot. However, Parsons warns that you need to ensure you are not sacrificing more than you’re gaining. He says: “Stick to your plan. It is easy to be irrational and make sudden changes, but these rarely improve your outcome in the long term.”
Prepare your portfolio
Ben Willis offers investment ideas for someone with retirement income from elsewhere (let’s say, a buy to let portfolio), who can take a few risks with their Sipp:
• Liontrust Sustainable Future Global Growth
• Vanguard FTSE Developed World ex UK Equity Index
• Fidelity Global Special Situations