Financial Conduct Authority  

What to know about investment risk in the early years of retirement

  • Learn about the relationship between risk and retirement and how that has changed with pension freedoms.
  • Understand why retirees tend to be risk averse and how this can be overcome.
  • Grasp what the FCA concluded about risk and how advisers can incorporate this into the advice process.
What to know about investment risk in the early years of retirement

The Financial Conduct Authority's (FCA’s) recent Retirement Outcomes Review Final Report mentions the word ‘risk’ 63 times. 

The report talks about longevity risk, the risk of scams and the risk of overspending, but the dominant theme is arguably the risk of over-cautious investors (mainly those without the benefit of advice) losing out by holding too much cash.

The paper sends a strong signal about the need to challenge clients’ inherent caution in later life.

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It arguably also sounds another death knell for lifestyling funds that automatically take risk off the table as the investor approaches their retirement date.

Breaking with tradition

In the days when nearly everyone bought an annuity, retirement represented the point at which you converted your pension savings into a guaranteed income for the rest of your life.

In that scenario, and with gilts also offering inflation-beating returns, there was some logic to the long-held tradition of gradually moving out of risk assets as you neared this important cut-off date.

But times have changed. Quantitative easing has made bonds look decidedly risky. Pension freedoms and longevity have forced a rethink of old traditions.

Back in 1980, when a man retiring at 65 could expect 13 years of retirement, a 15 per cent annuity was possible.

Today, when that life expectancy has stretched 40 per cent to more than 18 years, the same annuity packages now generate less than 5 per cent a year. 

Little wonder so many people are opting for drawdown – the FCA paper says twice as many pots are being used for drawdown than to buy an annuity since the pension freedoms.

But the longevity challenge that has contributed to the collapse of annuity rates remains for those in drawdown too.

There is now substantial evidence to suggest that the only way for many investors to make their money stretch throughout the whole of their retirement is to embrace a degree of investment risk. 

Research shows that in most circumstances, investors are better off leaving more of their portfolios in equities at and into retirement than they might have done traditionally. 

The reason is simple: people tend to be at their wealthiest as they near retirement age. This is the point at which their portfolios are at their biggest and the power of compounding has the most benefit.

For most people, this is not the time to be taking a foot off the risk pedal.

The evidence

One of the most important pieces of research in this area was conducted by Robert Arnott, chief executive of Research Affiliates in California.

In his landmark 2012 paper, The Glidepath Illusion, Mr Arnott simulated the performance of three distinct retirement strategies on the basis of more than 140 years of historical returns.