June 2007

A class balancing act

The traditional approach to asset allocation in the build up to retirement is, of course, well-known: a heavy weighting towards growth assets, such as equities, is gradually reduced over time to be replaced by cash and fixed income in the years leading up to retirement.

The reduction in equity exposure lowers the volatility and means there is less likelihood of a damaging one-off event substantially reducing the value of the portfolio close to retirement. A higher fixed interest weighting can also provide a hedge against annuity rates falling. This well worn asset allocation approach is perfectly suited to managing assets that will be annuitised at retirement.

However, given the steady erosion of state benefits and final salary schemes, non-pension savings such as Peps, ISAs and mutual funds are increasingly being used to supplement income from pension schemes and annuities. New needs require new solutions, and the traditional approach to asset allocation may not be the best idea for these "non-pension" assets. There are clear reasons why this is the case.

Longevity

Nowadays people are experiencing much longer retirements than ever before. In fact, a man who has reached the age of 65 in good health has a 50% chance of living to 87, and a 25% chance of reaching 92. For a 65 year old woman the figures are even more striking. She has a 50% chance of living to 90 and a 25% chance of reaching 96. This trend of living longer is set to continue - in fact mortality is increasing by around 2.5 years every decade - so it goes without saying that as life expectancy increases, so does the length of time for which assets will need to provide an income. For someone looking forward to 30 years or so in retirement, the key risk they face is that carefully accumulated assets could run out too early, or not adequately provide for their income needs. This would leave them in a precarious financial position at a time in life when they are possibly least well-equipped to compensate for it.

Given these extended periods in retirement - which for some people can be as long as the period they spent in employment - inflation becomes a big factor. An inflation rate of 3% can have a significant impact on a retiree's purchasing power. For instance, £50,000 of income today would only be worth £23,880 in 25 years in real terms. It is also worth remembering that we are in a period of low inflation. For the second half of the 20th century the average rate of inflation was 6%.

Role of equities

It is therefore imperative that those approaching retirement, and indeed those already in retirement, retain some exposure to investments such as equities that have the potential to beat inflation.

Long time horizons enable investors to wait out the inevitable ups and downs of the stock market. Retirees, especially those recently retired, and those approaching retirement need to recognise that longer life expectancy means that they too may have sufficient time to benefit from wise asset allocation strategies for their non-pension savings. Assuming they do retain exposure to growth oriented assets, they should also guard against the real danger of overreacting to a down cycle in the stock market by selling most or all of their equity holdings and aiming to meet lifetime income needs solely with cash and fixed interest investments.

Having large cash resources relative to needs might give someone who is about to retire or already in retirement a sense of security, but it could be an illusion. An ultra-conservative strategy can, over the longer term, prove highly damaging and significantly increase the danger of outliving one's assets.

I am not proposing that those at, or in, retirement should overload their portfolios with equities. The key to long-term success can lie in a defensive or balanced portfolio - a portfolio that is not all equities, which makes a person too exposed to bear market risk, but equally not all bonds and cash with their limited scope for appreciation of income and capital.

Research from the Fidelity Retirement Institute suggests that a retirement portfolio holding around 30% in equities with the remainder in cash and bonds provides the optimum balance of an immediate income with the potential for a rising income and capital growth. It may seem counterintuitive after the downturn of 2000-2003, but historical asset-class returns strongly suggest that retirees still need some exposure to equities for the long haul, although diversification remains critical, both in the selection of different asset classes and the choice of assets within each asset class.

Taking a balanced approach

However, no matter how smart one's asset allocation in retirement may be, it can all be undone by an overly aggressive withdrawal rate. If too high a withdrawal rate is selected, then this can significantly increase the risk of retirement savings running out too early.

Our research - using long-term asset class returns and up-to-date modelling techniques - suggests that a 4% starting withdrawal rate, assuming the investor wants that income to rise over time, may provide the optimum mix of income and longevity.

So, to sum up, investors should consider using different asset allocation strategies for pension and non-pension retirement savings. For savings that need to be annuitised, the traditional asset migration path where a portfolio transitions to all cash and bonds as retirement approaches is still very valid.

However, for non-pension savings, which may need to last for 25 to 30 years or more, growth assets need to be retained to some degree up to and throughout retirement in order to combat the real threat of inflation and provide a rising income over time.

Peter Hicks
Head of IFA Channel
Fidelity International