Freedom comes hand in hand with responsibility. With that in mind, how should pension scheme members respond to the freedom of choice that is now available to them as they reach retirement?
Most savers have never had, and possibly have never sought, investment decision-making powers.
More than 90 per cent of members in defined contribution (DC) pensions opt for their schemes’ default investment strategies, not least so they can avoid making these decisions.
Choosing pension freedoms means no longer opting out of decision-making. Instead, it implies accepting the responsibility for understanding and managing investment strategies in retirement – the drawdown option. There will be help available in the form of professional advisors, but some simple guidelines can also be helpful.
Perhaps the biggest issue facing many DC pension scheme members is whether they have saved enough in the first place. For this reason, it’s important to take an interest in pension savings well before retirement. Small rises in contributions made earlier can be much more beneficial than substantially larger increases made near to retirement. Pension freedoms are of limited value if the pension pot is insufficient to sustain retirement plans.
Deciding against buying an annuity is the same decision as accepting investment risk. In the past, retiring DC scheme members typically bought annuities, which ended their exposure to investment risk.
Schemes prepared for this by developing investment strategies that reduced risks for their members from around age 55. This risk tapering was designed to limit the impact of volatile performance on a retiree’s pension pot.
Pension freedoms require embracing investment risks for longer. For the vast majority of pensioners, taking their pension pots and depositing them in interest-bearing bank accounts will simply not earn high enough returns to fund their retirements. And that is not just a function of current low interest rates.
More than half of the wealth needed to sustain retirement has to be generated after working life has ended, and that requires taking investment risk.
For scheme members choosing pension freedoms, it is less appropriate to reduce investment risks 10 years from retirement because they will need to continue to take risks beyond retirement. There is no need to start tapering risks.
Volatile markets are a threat to all investors, but they are particularly dangerous in drawdown if retirees are committed to withdrawing a fixed sum on a regular basis. If the timing of the withdrawal coincides with market weakness, a greater proportion of the fund must be sold to satisfy the need for income. Then if the pensioner has sold at the low point, the fund has less gearing to recover when the market bounces back. This is the phenomenon of ‘pound cost ravaging’.
There are various ways to manage volatility of returns and minimise the impact of pound cost ravaging. One of these is to invest in lower volatility funds that can still produce the level of return required to fund retirement.
A second method is to be disciplined in withdrawing from the pension pot. For example, minimise withdrawals when investment performance in the recent past has been weak, and only take out higher amounts when performance has been strong. Think of it as a performance-related pension.
A third option is to divide assets on retirement into different risk pots. Invest some of the assets in cash, some in low-risk funds and the rest in reduced volatility but growth-related assets. The impact of pound cost ravaging is most acute in the early years of retirement. Using the cash and low-risk assets to fund the first few years of retirement can reduce the effects.
There is a widespread tendency for retirees to underestimate their own longevity and the compound effect of inflation, and hence to underestimate how big a pension pot needs to be to fund retirement. Around 50 per cent of 65 year olds alive today will be expected to live for at least another 20 years.
Over 20 years, if the rate of inflation is consistent with the Bank of England’s 2 per cent target, a pension payment would need to increase by 50 per cent to keep pace with rising prices. If inflation averages 3 per cent, the pension would have to rise by 80 per cent.
One feature of pension freedoms is the number of variables that individuals have to consider in weighing their options. Such is the nature of accepting responsibility.
David Bint is a multi-asset investment specialist at Standard Life Investments
