Lifestyle funds are like travel insurance policies – customers often don’t read the small print until something goes wrong. Auto-enrolment means a new generation of pension savers, many of whom will automatically pile into lifestyle funds without actually knowing it. This means it’s more important than ever that these savers understand what they’re invested in and why it’s a good thing.
For many employees and employers in the UK, the introduction of automatic enrolment means having to step into the
uncharted territory of workplace pensions.
Because of this fundamental change to the pensions landscape, the government estimates up to 11 million workers will be automatically enrolled into a workplace pension. However, typical investor behaviour isn’t likely to change significantly, in the short term at least.
Employees may be expected to save towards a pension but the vast majority won’t participate actively after enrolment.
While everyone’s free to opt out of their workplace pension, 70-90%
of employees are likely to join their employer’s scheme, invest in the default fund and stay there.
The Department for Work and Pensions’ (DWP) guidance about default funds highlights the importance of accommodating the needs of those who will be enrolled automatically. While no single strategy can suit all investors, the default option should be designed to deliver the best possible outcome for the majority of its members, recognising that many are unlikely to engage in financial decisions. And that’s exactly where lifestyle funds come in.
A common solution for scheme providers is to include a lifestyling component in their default fund. Lifestyle strategies generally assume that the investor will buy an annuity when they retire. They aim primarily to provide growth above inflation over the long term and to help reduce the impact of changes in annuity rates in the lead-up to retirement.
Usually such funds invest initially in growth assets then start a gradual switch to annuity-matching assets when the investor’s a predetermined number of years from their nominated retirement date. These changes to the fund’s asset allocation happen automatically so there’s no need for the investor to take any action.
While lifestyle funds are designed for those who want a ‘hands-off’ approach – that doesn’t mean they’re right for everyone.
That’s why it’s important that even those with limited interest understand what’s been chosen on their behalf.
Equities typically account for the bulk of the portfolio when the fund’s seeking to maximise returns during the growth stage – due to their potential for long-term growth. This is because while investors are still some way off from retirement, their portfolios potentially have time to recover from falls in value caused by major market upsets.
Of course, even if the dominance of equities for the growth stage is acceptable to professional investors, it may be totally unacceptable to many of your clients. And what constitutes long term these days seems to be stretching.
If you look at the 10- and even 15-year equity returns (as in the chart on the next page), global and UK equities are near the bottom of the pile. So it’s clear that, our view of when to disinvest from higher-risk assets should constantly be re-evaluated.
When the glidepath to retirement starts, a lifestyle fund’s emphasis shifts from growth to wealth preservation, by which we mean that it aims to preserve the size of annuity members can buy at retirement.
It seeks to do so by taking advantage of the inverse relationship between long-dated government bonds and annuity rates. This means that when one goes up, in normal circumstances the other will tend to go down. So when annuity rates fall, the value of a pension pot that’s invested in long gilts will tend to go up. Likewise, when the value of long gilts goes down, this can be an indicator that annuity rates may be higher.
The level of income the investor will get at retirement is less likely to change dramatically if the value of long gilts or annuity rates moves up or down just before they retire. This is why long gilts are still the asset class of choice for most
lifestyle strategies.
It’s worth noting that the relationship between long gilts and annuity rates isn’t perfect and can be affected by other factors, such as competitive pressures from annuity rate providers. Therefore, sometimes movements in long gilts won’t fully reflect movements in annuity rates. In addition, there’s typically a lag of a month or two between long gilt movements and annuity rate changes. And, of course, the strategy is only useful to investors who intend to buy an annuity when they retire.
Confidence in lifestyle strategies took a dive at the beginning of 2012 as gilt values, having rocketed in value in 2011, then fell sharply amid a period of uncharacteristically high volatility for the asset class. The overall return for long gilts in 2012 was a more modest 2.9%.
This caused consternation among those nearing retirement who had a considerable exposure to long gilts – and often considerably more than they had realised.
This is not suprising given their recent history. The volatile period that began in 2012 is easily explained given the sorry state of our own and other European economies, but this is an asset class that’s long been regarded as synonymous with the notion of financial security. The swings in performance have quite understandably alarmed some investors, particularly those close to retirement who thought they were investing in a low-risk asset class.
For more information about lifestyle funds www.aegon.co.uk/funds
