Why de-risking your pension is riskier than you think

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Conventional wisdom states that you should derisk your portfolio as you get older. You do this by shifting from equities into government and corporate bonds. Everyone is different, but at Fidelity a ‘middle of the road’ approach might be 40% in stocks and 60% in bonds, or a half-and-half split.

For some people, asset allocation isn’t static. They reduce their stock market exposure as they age, on the basis that their time horizon is shortening with every passing year. There is even a (very rough and ready) rule of thumb for this: subtract your age from 100 and this is the proportion of your portfolio that should be in equities.

Others use a cash buffer to manage volatility. Fidelity investment director Tom Stevenson experimented with this approach recently, in an article about how to deal with market crashes in retirement.

But there is another - somewhat counterintuitive - approach.

Rewriting the rulebook

In 2014, two American financial planners, Wade Pfau and Michael Kitces, published a paper called “Reducing Retirement Risk with a Rising Equity Glide Path”. It’s not the snappiest of titles, but the report grabbed the attention of the industry by proposing a startling idea: that people should increase - not decrease - investment risk as they age.

“Results show, surprisingly, that rising equity glide paths in retirement - where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon - have the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios,” the report concludes.

In other words, if you increase your exposure to stocks over the course of your retirement, you are less likely to run out of money and - if you do - the deficit will be relatively small.

In the study, retirees hold different combinations of stocks and bonds. Each pensioner withdraws either 4% or 5% of their portfolio in the first year of retirement and adjusts this income for inflation in subsequent years.

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Pfau and Kitces play this scenario out in a dizzying variety of ways, using different assumptions about investment returns and time horizons. In most cases, they arrive at the same conclusion: it is best to steadily increase your equity exposure throughout your retirement. Specifically, you want to start retirement with 20% to 40% of your portfolio in equities and steadily increase this to 60% to 80%.

This approach “generally performs better” than either static portfolios - where assets are rebalanced every year - or portfolios that scale back stock market exposure over time.

Tackling sequencing risk

To many people, this will sound like utter madness. Stocks lurch around, and the older you are the less time you have for them to bounce back. The risk involved is arguably unpalatable - particularly given the cost of care.

“Expenditure could increase significantly in later years if you need any type of care support,” says Lisa Whiting, policy manager for Fidelity's wealth management team.

“This means ensuring that you have an accessible, stable pot of money to cover this eventuality. As an adviser, I don’t want to put your money into a high-risk strategy at a point when you might need to make significant capital withdrawals to cover spending.”

So what is the reasoning? Well, it boils down to something known as sequencing risk. Two people can retire with the same amount of money and get the same average return over many years. However, if one of them experiences a market crash early on, that person is likely to end up much poorer.

• Read: How to deal with market crashes in retirement

Let’s imagine you have £150,000 in your pension and you take annual income of £7,500, increasing by 2% a year to keep pace with inflation. If markets rose by 5% a year for nine years, before dropping by 15% in year 10, your pension pot would be worth roughly £113,000 at the end of the decade.

However, if markets fell by 15% in the first year of your retirement, before rising by 5% a year thereafter, you would have just £95,300 by the end of the decade. Same average return, very different outcome.

This is because, in the second scenario, you are forced to sell investments when they are down, meaning you lock in your losses. Even though the market recovers, you have less capital to benefit from the uplift.

Pfau and Kitces argue that traditional retirement strategies can exacerbate this problem.

“In scenarios that threaten retirement sustainability, such as an extended period of poor returns in the first half of retirement, a declining equity exposure over time will lead the retiree to have the least in stocks when the good returns finally show up in the second half of retirement,” they say.

This does beg the question of what happens when circumstances reverse; when strong stock market returns in early retirement are followed by a fall. The authors are fairly blithe, however, saying “in scenarios where equity returns are good early on, the retiree is so far ahead it doesn’t matter”.

Picking holes

This underplays the issue somewhat. Limiting your exposure to equities early in retirement could result in missed opportunities, which in turn could weigh on future wealth.

The main problem isn’t mathematical, however, but psychological. While the logic behind rising equity glide paths makes sense, many people would find the strategy too risky, and there is a strong chance that some would lose their nerve entirely.

Nevertheless, the research serves a purpose for everyone. First, it is a useful reminder that managing risk in retirement is an art not a science. When everyone had to buy an annuity by age 75, it made sense to shift heavily into ‘safe’ assets. Noone wanted to experience a stock market crash on the eve of their 75th birthday. Under the new rules, however, striking a balance between safety and growth is far more nuanced.

The contrarian strategy also shines a light on sequencing risk, which looms larger than ever in today’s unpredictable world.

If you are worried about sequencing risk, there are some other strategies you could consider.

• Bucket approach. This involves dividing your fund into three buckets: cash, bonds and equities. The cash bucket might equate to two or three years of income and is there to help you ride out market falls. Another four years’ worth of expenses would be kept in bonds, and the rest in global equities and other growth assets.

The idea is pleasingly simple, but it throws up problems. At the end of the year, it will be time to top up your cash bucket, and you’ll need to sell stocks or bonds to do this. Which do you sell? And what will this do to your asset allocation over time?

Depending on how you approach your annual rebalancing, the bucket approach can morph into something like a glide path.

• Natural yield. Some investors choose to live off ‘natural yield’- the interest, dividends and income generated by their assets. This means you don’t sell any underlying investments, which means you avoid locking in losses when markets fall. The obvious disadvantage is that income is likely to vary year by year.
• Variable income. Some retirees base how much income they take on the performance of their investments, withdrawing less when markets are falling. To know exactly how much to withdraw, you can take a fixed percentage of your fund value each year (as opposed to a fixed percentage of the initial fund value).

This mitigates sequencing risk but - as with the option above - your income will jump around.

The government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.co.uk or over the telephone on 0800 138 3944.

Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

This article was first published in Investors’ Chronicle

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