August 2008

Is lifestyling the answer?

In the next 12 months alone there are approximately 350,000 people planning to retire. The risk of volatile markets, plunging house prices and rising inflation is a real concern for them and others looking to retire in the next five to ten years1 but where can they turn? Should they stay invested in equities and hope the recession doesn't bite too deeply? Should they play safe and head for the cover of cash and fixed interest? Or is there another way to protect their future retirement income?

For those advisers working with clients who are planning to retire shortly, equity market volatility is a key concern at present. That's because the potential fall-out of an equity market downturn is in fact heightened when you combine this with longevity trends and falling bond yields.

As all advisers are aware, when these three elements of equity market risk, longevity trends and bond yields combine it can lead to dramatic changes in a relatively short period of time.

During the early 2000s we had a situation whereby the FTSE All-Share index fell by 30%. In addition, long bonds yield fell by 1% at the same time that the projected life expectancy of a 65 year old man increased by 10%2.

Taking these factors together, someone who had been invested in a unit-linked retirement fund in the run up to retirement could have found that the combined effect was to reduce his annual retirement income by 50% during the space of a few short years.

Faced with today's market conditions, advisers need to ensure they consolidate the gains achieved over the good years in order to protect their clients' future income as they approach retirement.

Is lifestyling really the answer?

In recent times, lifestyling has become a popular way of giving some protection to investor's retirement savings. However the technique of gradually shifting pre-retirement assets from equities to bonds on a predetermined basis would appear contrary to the popular view that 90% of performance is due to asset allocation.

That's because where good asset allocation uses present and predicted market conditions to maximise performance, lifestyling simply uses an algorithm to move money from equities to bonds, with little thought given to whether the change in asset allocation is appropriate at the time the deal is executed.

Indeed as Cazalet Consulting reports, it may be wholly inappropriate and possibly downright dangerous in some circumstances. It could lead to investors withdrawing from equities during a down-cycle at the same time as locking themselves out of any sustained recovery3.

In an analysis of FTSE All Share Index annualised returns from the start of 1992 through to the end of 2007, Fidelity International found that staying fully invested in equities throughout the period would have resulted in an investment return of 9.84% per annum compound, while staying invested for all but the best 10 days during that period would have cut the overall investment return to 6.89% compound. Missing out on the best 30 days would have slashed the total return to 2.78% compound4.

As Cazalet Consulting have said: "The hidden complexities and uncertainties attached to lifestyling take the concept of tripping up on market timing a stage further and make this a perhaps unexpectedly hazardous financial planning solution."

Living benefits for pensions

If asset allocation is really the key to good performance, can we really say that using a predetermined switching pattern is the most effective investment strategy? Or is the key to unlocking superior performance in giving the investor the confidence to remain invested in equities until they retire?

Since 2005 'Living Benefits' have been available for UK investors in the form of optional guarantees. These guarantees are now available with a personal pension plan and ensure that an investor's future retirement income will never go down. As a result they are proving increasingly popular since they give investors the confidence and flexibility to remain invested in a portfolio that best suits their attitude to risk, throughout their pre-retirement planning stage.

Living benefits vs lifestyling

Cazalet Consulting plotted the automatic lifestyling out of equities into bonds over 10 years against The Hartford's Guaranteed Retirement Income Plan. What they found was that over the 10 year period shown, The Guaranteed Retirement Income Plan resulted in a 22% boost to net investment growth (i.e. the Income for Life outcome of +70.8% is 22% greater than the 58% achieved through lifestyling).

As a result they commented that "The Hartford's approach of facilitating stable asset allocation in the form of continued exposure to equities with no downside risk, plus the ability to lock in a substantial degree of upside from period to period, in many cases should be superior to using a somewhat clunky and formulaic 'lifestyling' approach5.

A superior approach

The advantages of 'Living Benefits' over lifestyling we believe are clear. Given that history suggests that equities outperform bonds by an average of around 3.8% a year and that the cost of protecting the equity portion through a Living Benefits plan could cost less than 10% of this gap, then the advantages are appealing.

In addition to providing valuable transparent guarantees at an attractive cost, they can also provide a smooth and seamless investment experience across the pre-retirement/in-retirement divide. As a result Cazalet Consulting remark that: "Living Benefits would appear to be very much preferred to lifestyling when it comes to maximising the client's investment fund and, thereby, boosting his or her financial resources and income in retirement."

1. The Telegraph, 19 March 2008.

2. Cazalet Consulting 'Living Benefits: The Investment Holy Grail.' 2007.

3. Cazalet Consulting 'Living Benefits: The Investment Holy Grail.' 2007

4. Source: Fidelity. FTSE All Share annualised returns - 31/11/1992 to 30/11/07.

5. Cazalet Consulting 'Living Benefits: The Investment Holy Grail.' 2007.

Michael Rudge
UK branch, Managing Director
The Hartford