Need to know:
- Lifestyle funds gradually move an employee away from high-risk, high-return assets into lower-risk, lower-return assets as they approach retirement.
- Following the introduction of the pension freedoms, fewer people are buying an annuity, which raises the question of whether lifestyle funds are an appropriate default strategy.
With the introduction of the pension freedoms from April 2015, there is a question hanging over lifestyle funds as to whether they are still appropriate for an employer’s default investment strategy.
A lifestyle fund gradually moves an employee away from high-risk, high-return assets at the start of their employment, when they have around 30-35 years to retirement, into lower-risk, lower-return assets the nearer they get to retirement. The logic of this investment strategy is that when an employee first starts contributing to a pension, hopefully they will be quite young and a long way from retirement, so can afford to take on risk at this point.
Becky Tilston-Hales, director, strategic project management at BlackRock, explains: “[Employees should] take on the risk early, try and grow their pension pot as fast as they can, and then try and reduce the risk as they get nearer to retirement. They’re less able to tolerate a big loss in their pension pot the closer they get to retirement, because they’ve less time to recover that loss again in the market. It’s about derisking the closer they get to retirement and then getting ready to take their assets and retire.”
The time an employee chooses to start derisking depends on their own views, but one of the challenges of lifestyle strategies is that employees do not always know when they are going to retire; the strategy assumes an employee will have a rough idea. “Different investment houses will have different views on their retirement glide path, which would dictate the risk return level at what stage [an employee is] in their retirement journey,” explains Tilston-Hales. “Typically people might start derisking around 15 to 10 years prior to when they expect to retire. “The investment strategy can be only as precise as people’s own knowledge at the age of 25 as to when they might want to retire.”
A default strategy needs to be suitable for a diverse workforce, which presents another challenge for employers, says Paul Todd, director of investment, development and delivery at the National Employment Savings Trust (Nest). “One investment strategy may be more important for people in their 20s, but they may need a very different approach when they get in to their 40s or 50s, or approach retirement,” he explains. “So [employers need to] make sure that not only is the default strategy right in a broad sense for a particular workforce, but that it is also able to adapt as people go through their careers and have different needs at different ages.”
Pension freedoms
Pre-pension freedoms, the expectation was that almost all employees would buy an annuity as the end-point of a lifestyle strategy that would point towards investing in asset classes. Tilston-Hales explains: “That meant that the investment mix that [an employee] had in their pension pot moved from almost 100% in equities at the beginning to something that was almost entirely in gilts, and long-dated gilts because that best matches an annuity-type strategy. That makes a lot of sense if everyone is going to annuitise, but that strategy makes less sense if people want to take all their money in cash, or if they want to stay invested in the stock market and draw down an income from an invested portfolio.”
Now the industry is questioning if a lifestyle strategy is applicable if employees are typically not going to annuitise. Nick Dixon, investment director of Aegon, says: “In my judgement, lifestyling, where the provider undertakes the derisking towards the end of the retirement journey, still has a very important role to play. I think it is very important that people derisk towards the end of their journey otherwise they could be significantly out of pocket just at the time that they need that capital.”
The pension freedoms offer employees much wider choices and it is just as important now as it ever has been for pension members to be provided with clear communication and investment information, says Dixon. “I think there needs to be more [communication] in general from employers and providers,” he says. “And, as part of that, we need to engage people in a simple clear way, and provide tools to make it easier for people to make their own choices. We need to develop more engaging conversations for investors about their pensions.”