When you’re building your pension up, what you’re looking for from your investments is well defined: growth. Likewise in retirement, for most people, the goal is simply to generate income. But there is a period in the lead up to retirement, when things are a little more nuanced.

During the financial crisis the typical global equity fund fell by 30%. That’s not something you want to happen just at the point you’re about to draw your pension. So, you want to protect your pension from big market downdrafts. But at the same time, you’ll still want to experience some growth in your pension in your final years of working, as well as preparing for drawing an income in retirement. This can create a bit of head scratching when it comes top setting an investment strategy in the retirement runway.

THE LIFESTYLING APPROACH

The traditional approach to this conundrum is called lifestyling. As you approach your chosen retirement date, your assets are gradually moved out of equities and into bonds, in order to hedge against annuity rate movements. Bond prices move in the opposite direction to annuity rates, and so the idea is by investing in these ‘annuity hedging’ funds you can reduce your retirement income volatility. While that might be true if you’re buying an annuity with your pension pot, this doesn’t actually reflect what most people are now doing with their pension. Only around 10% of people are currently buying an annuity with their pension, compared to around 90% before the pension freedoms were introduced almost a decade ago.

This opens investors up to a big risk. Over the course of 2022, the typical annuity hedging fund used as part of a lifestyling strategy fell in value by 36%. Annuity rates went up at the same time, but if you’re not buying an annuity, that 36% decline represents a pension hit every bit as bad as being invested in a global equity fund during the financial crisis. For many then, the traditional lifestyling approach is now an inadequate, outdated strategy.

Nonetheless many older pensions, such as group personal pensions or individual personal pensions like stakeholders, still automatically implement a lifestyling approach on behalf of investors. If you have an older pension, typically provided by an insurance company, you might want to check if it’s programmed to start investing in annuity hedging funds as you get closer to retirement.

THINKING ABOUT THE FUTURE

What the widespread failure of traditional lifestyling throws into focus is that in order to plan an investment strategy that leads into retirement, you do need to think about how you’re going to draw your pension when the time comes. If you’re one of the minority of people who are planning on buying an annuity, then the traditional lifestyling approach might well work for you. But many more people are now taking the two other options opened up by the pension freedoms: cash and drawdown.

For those who are taking their entire pension as a cash lump sum it makes sense to have their pot held in cash, or cash-like money market funds, as they approach retirement. This protects them from large market falls just as they are about to cash in their chips. One of the things we can salvage from the traditional lifestyling approach is the idea of a gradual shift in your assets as you approach retirement.

This helps smooth the journey and means you aren’t caught out by a big market repricing just as you leap from one investment to another. For those taking their entire pension as cash,  this would mean slowly shifting towards having 100% of your pension held in cash. Even for those buying an annuity or taking drawdown, building up some cash makes sense if you’re planning to take your 25% tax-free lump sum at retirement.

DRAWDOWN OPTIONS

For those taking drawdown, where you keep your pension fund invested in retirement and take an income from it, the thinking cap needs to stay on for a bit longer. It’s still probably prudent to gradually shift your pension pot, but the question of what you are moving towards depends on your risk appetite and how you want to invest in retirement. It’s probably a good idea to put together  a target portfolio, which is how you want your pension to look at the point of retirement, and steadily move your investments across to the new strategy.

You might actually end up keeping some of your holdings though. That’s because you’ll almost certainly want to retain some exposure to shares in a drawdown account, though most likely with a greater focus on income rather than growth. Even so you may still want to hang on to some more growth-orientated shares and funds in the interests of having a diversified portfolio, and you can always generate an artificial income from these assets by taking profits and withdrawing the proceeds.

If you’re going to transition your investment strategy in the approach to retirement, you also need to decide when to start the switch. There’s no hard and fast answer here but conducting a pension review 10 years before retirement is normally a good idea, first to check you’re on course to meet your retirement goals, but also to consider your investment strategy going forward. By the time you hit five years to retirement you should really be starting to transition your investment strategy, if you haven’t already. Giving yourself more time allows you to adjust to market conditions. If there’s a big drop in share prices you can delay shifting out of equities until there’s some recovery, provided you haven’t boxed yourself in by leaving things till the  last minute.

DO-IT-YOURSELF

It’s perfectly possible for investors to navigate the transition into retirement themselves if they are willing to roll up their sleeves a bit. It might help to consolidate pensions in one place to make things simpler on this front. It’s quite common to accumulate multiple pots spread across different providers, and it’s hard to implement a joined-up investment strategy across so many different pensions. If you want a helping hand, you can always seek out the services of a professional financial adviser, who for a fee will provide recommendations tailored to your particular circumstances.

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