It is the received wisdom of most pension experts that it is sensible for investors to reduce risk in the run-up to retirement to protect their pot from any sudden falls in equity markets. That typically means increasing exposure to bonds and reducing equities, a process commonly adopted in ‘lifestyle’ funds. But that received wisdom is being questioned by two dynamics – the fear of a bubble in bond prices and the growing popularity of a new method of reducing risk called ‘target-date’ funds.
Many advisers are starting to question whether lifestyle funds are providing their clients with the protection they need. So should advisers be wary of lifestyle funds or recommending that their client take an alternative course of action?
The bubble effect
There has been talk of a bubble in bond prices for the past two years and that fear has grown recently. It is well known that prices of gilts have been driven up by quantitative easing (QE), which has seen the Bank of England buy £375bn of bonds – almost entirely gilts – accounting for almost one third of the total market. Combined with fluctuating fears of further bouts of economic crisis in the eurozone – which has seen increased demand for comparatively safe-haven assets such as gilts – the price of gilts has risen to an all-time high, with 10-year gilt yields in May falling below 1.7 per cent.
In February, Moody’s downgraded the UK, stripping the country of its prized AAA credit rating and Fitch followed suit in April. But on neither occasion was there a tangible dent in gilt prices – demand remained as high as ever despite significant and worsening problems with the UK’s national balance sheet. In April, Fitch cited “a weaker economic and fiscal outlook” following the IMF’s assessment that same week that the UK’s 2013 growth forecast should be cut to 0.7 per cent from 1 per cent.
Many experts now fear that unless the Bank of England expands QE, the price of gilts could tumble to a more realistic level that properly takes account of the real credit risk of the UK (see Graph 1). As equities continue to perform well there are also concerns of a ‘great rotation’ that could see investors selling out of bonds in favour of equities, causing further damage to bond prices.
Of course, neither of those fears may materialise. Investors may continue to be wary of equities and the BoE may indeed expand QE at the request of a government desperate to maintains its low borrowing costs.
But the risk is real, and for low-risk investors who have turned to corporate bonds in search of higher yield, the risks of capital loss should gilt yields rise are even greater. Gilts are often called the risk-free asset but could they become the return-free risk asset?
Lifestyle vs target-date funds
Investors in lifestyle funds which automatically switch them from growth assets to corporate and government bonds in the final 10 years of accumulation, will find themselves building up quite a store of expensive bonds funded by selling much higher yielding equities. The volatility of gilts has been remarkably high in recent years – around 6 per cent standard deviation per annum – but they remain technically lower risk, as has historically been the case, with very limited scope for further growth.
On the other hand, should yields rise to a more historically typical 3 per cent, gilt investors would suffer an 8 per cent capital loss. That is the fear that is causing experts to have a second look at the lifestyle process.
At the same time, target-date funds are becoming popular. Instead of automatically swapping equities for bonds on set dates, a target-date fund is managed by an investment team allowing them to exercise discretion over asset allocation changes. This, in theory, puts target-date funds in a better position to avoid risks of capital loss caused by perceived bubbles in the market.
IFAs with clients using lifestyle funds have a potentially tricky conversation. The bonds used by lifestyle funds are designed to closely match the bonds that are used to determine the price of annuities. By building up a portfolio of longer dated gilts and index-linked gilts, investors are protected from future changes to annuity prices. In this instance, were the price of gilts to fall suddenly the cost of annuities would fall in line, so the individual would be able to purchase the same level of income even though their pot has shrunk in size because it was heavily invested in gilts.
Problem areas
There are two main problems with this for an adviser. Firstly, were the bond bubble to burst, would your clients be happy if they lost a significant portion of their pot, even if their annuity income purchasing power had been preserved? Secondly, how sure are your clients that they will be retiring near the date that their lifestyle fund expects? If retirement is delayed, they could be de-risking too early, missing out on significant potential growth at a key time when their potential for growth is at its highest.
This is a difficult dilemma. If gilts are not low-risk, then what is? Cash is the only realistic option for clients concerned about the risk of capital loss in gilts. But while cash will manage the risk of capital loss it will not tackle the risk of annuity prices rising – and it provides almost no income or growth. Diversified multi-asset funds may be a sensible option for some clients, particularly those who plan to retire later and for whom a lifestyle fund set to the wrong date is particularly inappropriate. Many of these funds are able to deliver healthy returns for a much lower volatility than equities, albeit higher than gilts.
For clients further away from retirement it may be worth considering alternatives to lifestyle funds even if they will not start to derisk for many years. Target-date funds are the mainstay in America, and many of the US-based fund managers operating in the UK retirement market are migrating away from lifestyle towards what they believe is an inevitable trend towards target date.
Standard approach
With Nest, the government’s auto-enrolment scheme, and many other auto-enrolment schemes adopting target-date funds, this looks likely to become the standard approach over the next few years. As well as offering a more managed approach to derisking, target-date funds are also more flexible for those who plan to change their expected retirement date, allowing them to simply switch into the fund set to mature when they retire.
IFAs who have recommended lifestyle funds may at one point have hoped the fund would not need to be monitored closely. That is unlikely to be the case at the moment, but fortunately there are some good alternatives, which advisers can consider with their clients.
