Shock-proof investing

Shock-proof investing

The investment and fund market, in the UK at least, is still geared much more towards accumulation rather than the lead up to retirement and decumulation phases of the investor’s lifecycle.

In these later stages, market volatility can have a devastating effect on a fund from which withdrawals are being taken. When an investor is making regular withdrawals, as he will do in retirement, a portfolio with fewer large losses and gains will more likely preserve capital better than one with more ups and downs in its value. This is due to the fact that when a withdrawal is made after a market decline, the funds are no longer there to benefit from any subsequent market recovery and make up the lost value.

Therefore, with greater volatility (as well as earlier negative returns after one begins to withdraw his income) it is likely that the pension pot will run out more quickly. Similarly, with less volatility the pension fund is likely to last longer.

Article continues after advert

In the past there have really been two possible investment strategies for clients approaching retirement to follow:

• Staying invested, usually with the majority of their fund in the stockmarket (that is, equities) but probably some diversification into other asset classes too

• De-risking their investments (switching to lower risk assets) or using‘lifestyling’, both similar in approach

The advantage of staying invested is that exposure is maintained to equities, which have historically provided the best returns over the long-term. Equities, though, have also been one of the most volatile asset classes and have seen some big falls in recent years, for example, the ‘dot-com’ crash of the early 2000s and the credit crisis in the late 2000s, therefore the client risks losing a significant portion of his pension savings.

Even if the fund is diversified, however, it may not be protected from a market shock. In the dot-com crash, while equities fell heavily, the other main asset classes generally provided positive returns, with the result that a diversified fund would have fallen a lot less. Following the credit crisis, though, almost all asset classes declined in value, apart from high quality government bonds. In this case, even a well-diversified portfolio would have suffered big losses.

In the case of de-risking/lifestyling, the risk of the fund suffering from any market shocks are reduced as the fund is moved out of equities and into fixed interest. There are, however, the following disadvantages to this approach:

• The fund misses out on the growth potential of equities

• There is the issue of market-timing - due to the fixed nature of lifestyling, the fund could end up selling equities at low points and buying fixed interest investments that are overvalued

• Again, due to this being a fixed process, with the switches and their subsequent asset allocations being based on years to retirement, this strategy may not be suitable if the client retires earlier or later than expected