The FT’s headline and accompanying article touches the symptom not the cause of the problem facing DC savers. In more technical language, Lex explains
Mature savers who were shunted into bonds at record-high prices may now find their lifestyle fund will no longer finance the retirement lifestyles they planned for.
High allocations to bonds have led to serious losses for some savers, in particular where the lifestyling hasn’t included an allocation to money market funds, preparing savers for a drawdown to cash.
Here is a fairly typical lifestyle fund, operating at the back end of the Virgin Money Stakeholder plan.
The fund was set up relatively recently to provide savers with security in later life. Virgin (rightly) point out that the fund has done better than many of its peers, but its return in 2022 of minus 9.25% was of little comfort to savers facing plus 10% inflation. They had lost pretty well 20% purchasing power with their money.
The average “lifestyled” pension fund produced a negative return of 9.8% to savers in 2022, prompting Virgin’s IGC to give the defensive fund a green flag for Value for Money.
Other lifestyling fund such as BlackRock’s Flexi LifePath fund which didn’t have allocations to cash , fared even worse. What kept Virgin’s fund above the average returns were the allocations to cash and the 17% of the fund kept in shares.
Why are bonds considered safe?
It is very hard to explain to ordinary savers, why investing in Bonds is “safe”. The reality is that the Prudential Regulatory Authority require insurance companies to back their annuities with bonds so it is received wisdom that in the long-term, bonds are low risk. But savers within a year of their retirement are ordering for themselves ” a different lifestyle” than is envisaged by a guaranteed annuity. A quarter of people’s pension savings will typically be drawn as tax-free cash while the remainder typically stays invested either in the lifestyle fund, or is switched to a self-invested drawdown plan (often set up by an adviser) or in a non-advised investment pathway selected by the saver,
About 10% of the pathways lead to immediate or deferred annuity purchase, the remainder target passing on the pot as an inheritance, or as an immediate drawdown to cash or as a means to access cash using flexible drawdowns.
Since the average life expectancy of people making retirement decisions is over twenty years, the investment of a fund designed to last as long as the saver does, would expected to have a long-term feel about it. In short, it would not be invested as a typical lifestyled defensive fund is structured. Over 20 years, bonds are likely to lag equity returns, de-risking is unsuitable for people with a 20 year + time horizon.
The idea that bonds are considered “safe” is an inheritance of insurance company investment strategies for annuities, but their use within lifestyled funds means that unless a saver consciously moves away from the lifestyle, the lifestyle they ordered (in terms of retirement financial security) is “out of stock”.
We should be questioning the concept of “de-risking” retirement savings.
Typical allocations to drawdown plans involve 40%+ being invested in equities and equivalent growth assets. Allocations to occupational pensions which remain open , often have 60% allocated to equities and growth. Where the aim is to maximise growth rather than guarantee the drawdown rate, the allocation to equities and growth assets can be even higher.
The longer the anticipated duration the pension is expected to be paid for, the more growth assets can be held. It is only where there there is a hard-stop to the pension plan that de-risking into bonds and cash becomes attractive. Necessarily, annuities have a hard stop. Even a bulk annuity arrangement has a hard close. The PRA is right to enforce solvency rules on guaranteed annuities and require the guarantees to be secured by bonds with matching liabilities.
This has led to de-risking being seen as inevitable
Default allocations to lifestyle funds are a “necessary evil” for pension managers responsible for thousands of people, said Laith Khalaf at AJ Bell.
But this is wrong. There is no fundamental reason that our lifestyled incomes in retirement should be constrained in such a way.
The alternative is to think of ourselves as part of a collective pension arrangement where the income we lose when we die will be paid to the next person and the money that pays that income comes from people who have yet to retire.
This idea that pensions are fungible and therefore have no end date has almost been lost over the past twenty years. It persists in the state pension, in the few remaining funded DB plans (LGPS, USS , Railpen and many smaller schemes that refuse to be fast-tracked to insurance). It will be there at Royal Mail when its CDC opens its doors and it may return to DC if we can find a way to capture its pots and turn them into collective pensions.
Lifestyle is the symptom not the cause of the problem
The de-risking of pensions, known as “lifestyling”, exists because we have turned pensions from collective expressions of mutual endeavour to a means of personal wealth management.
For many people , the pot is better than a pension, many people relish the freedom to manage their retirement affairs by drawing down money when its needed. Such people will typically have problems having too much money (capital taxes for instance).
But most people don’t pay capital taxes and live off their income, they want to swap their wage from work for a wage in retirement and they’re happy to be part of a scheme (such as the state pension) where things are done for them. The bulk of the population has been captured by the dream of wealth but that dream is not the reality of their financial lives as they leave work for retirement.
The underlying principle of individual DC accounts is not what they ordered, they ordered dignity in retirement and they saved what they were told to (sadly not enough in many cases).
Lifestyling presents people with a “de-risked” solution, but it is the PRA and the insurance company’s solution. It is not the lifestyle that people ordered and people who are told they have got value for their money after their pot shrunk in real terms by 20% in 2022, are entitled to turn to their workplace pension providers and ask why they haven’t got the lifestyle they ordered.
They’d be protesting much louder if they knew that there was an alternative , which has sat on the shelf for the past 15 years but is marked “not in stock” – I speak of course of CDC and occupational scheme pensions.
To be completely accurate, the Virgin Defensive fund comprises 64% at the end of the glidepath – significant, but not all of it – with the VM Growth Fund 3 comprising 36% (of which 80%+ in growth assets).