If you are not going to buy an annuity you may have to rethink your entire investment strategy

9th April 2014

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Looking forward to enjoying not having to buy an annuity with your pension? You’d better make sure your investment strategy is in order if you don’t want it all to go horribly wrong writes pensions journalist John Greenwood.

It is great that you no longer have to buy an annuity or other long-term income with your pension pot. But the chances are your pre-retirement investment strategy is now putting you into the wrong types of asset. The fact is, the Chancellor’s revolutionary assault on annuities has rendered obsolete the investment strategies of millions of pensions savers.

Before the Budget everything was simple for the people designing our pension schemes.

Because nearly everyone bought an annuity when they retired, workplace pension schemes set their targets on investing your money so you could get a secure annuity income in retirement.

But since the radical Budget changes, annuities are, for millions, suddenly off the agenda. Some analysts predict the number of people buying annuities could shrink by two-thirds.

Rather than one clear option at retirement, there are now three: using your pot to buy an annuity, drawing it out as a cash lump sum or reinvesting it in the stock market and drawing an income from your shares.

The problem is, 90 per cent of defined contribution pension schemes operate a strategy called ‘lifestyling’ because they presume you want to take the first of these three options.

Lifestyling is designed to take the risk out of stock market investing. If you were invested 100 per cent in equities and the stock market fell 20 per cent the day before you retired, you would be pretty upset.

A lifestyling strategy sees a percentage of your assets moved out of risky equities into more secure assets such as gilts, which are backed by the UK government, in the years before your retirement. Rather than switch to gilts on a single day, when markets could be low, pension investors’ assets are switched a bit at a time, so that by the time you retire, you have no exposure to equities whatsoever. Gilts are long-term promises from the UK government to pay a fixed income for a number of years, typically 10 or 15 years for the ones in lifestyling strategies. The 15-year version returns just over 3 per cent at the moment.

This is where it gets a bit complicated, but stick with it because it is pretty important.

Gilts are known as being the most secure assets in the investment universe, which they are if you hold them until they mature. But they are not if you sell them before their term has expired. In fact, far from being rock solid, traded gilts go up and down in price all the time. In 2011 the UK gilt sector returned 15 per cent, which is great for people who hold them, but not what a boring secure asset is supposed to do.

This volatility never mattered when we were almost all aiming to use our pension to buy an annuity. In fact, that is precisely why pension schemes invested in them, because they hedge against the risk that annuity rates would go against you just as you approached retirement.

When annuity rates go down, it is often because interest rates have gone down.

But when interest rates go down, gilts go up in value, meaning the pension saver has a bigger pension fund with which to buy an annuity. The combination of the increase in the value of the gilts compensates for the fall in the annuity value, meaning the annuity income the investor gets is broadly the same.

That was all well and good when annuities were the only game in town. But being 100 per cent invested in gilts at retirement is no good for you if you are planning to take your fund as cash or invest it in shares. If the opposite of what happened in 2011 happened just before your retirement, far from being a secure investment, you could lose 15 per cent of your life’s savings.

The upshot is, all investors now need to get the best possible idea of what they will do with their cash when they retire – cash it in, invest in shares or buy an annuity. If you think you will end up with anything other than an annuity, you are going to have to rethink your investment strategy completely.

1 thought on “If you are not going to buy an annuity you may have to rethink your entire investment strategy”

  1. Noo 2 Economics says:

    “But being 100 per cent invested in gilts at retirement is no good for you if you are planning to take your fund as cash or invest it in shares. If the opposite of what happened in 2011 happened just before your retirement, far from being a secure investment, you could lose 15 per cent of your life’s savings”

    A pension planner would start slowly moving a person’s assets into gilts about 10 years before their expected retirement date gradually increasing the velocity of the move the nearer the retiree got to retirement age.

    So in the last 5 years they would be buying lots of gilts, now, what was the price of gilts 5 years ago and what is the price today? Overall they are significantly lower now than over the last 5 years, so the pension planner would have delivered a tidy loss
    to you with which to fund your annuity. Indeed, he would have done as badly and may be worse than an amateur private investor could have done had he taken his pot 5 years ago and invested it in a mix of shares and bonds.

    This strategy rethink argument is ridiculous!

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