Piecing together the portfolio de-risking puzzle

A good way to approach retirement planning is to think about it as a series of puzzles.

The first riddle is how to save enough without comprising other financial priorities, while further down the line you need to figure out the best way to use your accrued pot to fund a comfortable life.

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Sandwiched between these two phases is a further puzzle. And like the others, it’s a tricky one to solve.

As you enter the final years before retirement, the quandary is whether to consolidate gains and gradually move into less volatile assets. This is a process known as de-risking and involves switching parts of your portfolio from shares into bonds and cash, typically over several years. The idea is that as you age, you have less capacity and time to absorb stock market falls.

However, a method designed to offer a ready-made solution, pension lifestyling, made the headlines this week, and for unfortunate reasons. According to an article in The Telegraph, the volume of complaints about these strategies almost tripled last year after government bonds fared badly in the wake of rising interest rates. This caused retirement pots to plummet when savers assumed they were somewhat protected.

Pension lifestyling has been placed firmly under the microscope ever since pension freedoms, allowing you to draw from your pension however you wish, came into force in April 2015. Many experts claim a rigid, automatic de-risking approach is now outmoded – especially for those who wish to keep their savings invested throughout retirement and draw income flexibly.

But like all investment strategies, there isn’t a one-size-fits-all solution. We all must piece together our own de-risking puzzle, based on how we plan to draw retirement income, our current asset allocations, and personal appetite for investment risk. The difference between getting it right or wrong can have implications for your financial comfort later in life.

Here we’ll look at the various things you may wish to consider, and explore your options when seeking to reduce portfolio risk.

The freedoms effect

Investor approaches to de-risking have shifted since the pension freedoms took effect.

Before this watershed piece of regulation came into force, most savers bought a guaranteed income for life with their pension pot in the form of an annuity.

For anyone choosing to head down this path, moving into safer funds as you near retirement can make a lot of sense. If your portfolio tanks 20% a few months before you plan to draw an income, your retirement plans could be thrown into disarray.

Once you’ve secured a lifetime annuity, the terms you choose at the outset are irreversible - there’s no turning back. As such, consolidating your gains in the pre-retirement years can be a sensible move.

But, as some of those who’ve adopted lifestyling strategies have found, automatically moving into what are deemed safer investments provides no guarantee that your portfolio will weather the storms.

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What’s more, in the past 10 years annuities have fallen heavily out of favour. Instead, savers are preferring to keep their pension invested and draw income flexibly.

As people still buy annuities, arguments for strategic de-risking still hold water. But for those eyeing up drawdown, heavily reducing investment risk could do more harm than good. That’s because the money might be invested for several more decades, and portfolio growth is crucial to ensure withdrawals keep pace with inflation.

Still, drawdown investors shouldn’t necessarily rule out adopting a more defensive stance. Sequencing risk, which occurs when you withdraw income at the worst possible times, has the greatest impact in the early retirement years. Steeling your portfolio for this as you approach later life often involves having at least some holdings in safer investments.

Two ready-made de-risking strategies unpacked

• Target retirement funds

Investing giant Vanguard has developed its own solution to help investors solve the asset allocation puzzle as they move through life: Target Retirement Funds.

In Vanguard’s words, it’s a “ready-made portfolio that makes investing for retirement simple. You simply choose a fund based on when you plan to retire and we do the rest”.

So, how do these work?

In a nutshell, up until age 45, the fund allocates 80% and 20% to equities and bonds, respectively, spread across a selection of Vanguard funds. The fund gradually de-risks until age 75 when weightings settle at roughly 70% bonds and 30% equities.

You can see why such funds may appeal to some investors, especially those who like to stick their money away and forget about it. They take asset allocations off your shoulders and help to smooth out market downsides. It adopts a similar ethos to the “100 minus age” rule (subtracting your age from 100 equals the percentage of your portfolio that should be allocated to equities), without you having to manually adjust weightings every few years.

Some, however, may feel the de-risking process starts too soon. The outlook for bonds is far more promising than the returns produced in the previous decade. But the stock market still offers the better prospect for growth over longer periods. Reducing risk 30 years from retirement may seem overly cautious to more adventurous investors.

• Lifestyle strategies

The same claims can be angled at lifestyle strategies.

These come in a few different flavours, but all follow a similar theme. Like Vanguard’s Target Retirement Funds, they gradually and automatically move holdings from riskier assets, mainly equities, into bonds and cash. But the process happens over a shorter time frame – usually either five, seven or 10 years – and is more aggressive. By the time you reach retirement, equity allocations are often reduced to zero.

As noted above, they were designed when most people bought annuities, so you can see the logic here. A stock market slump shortly before the point of needing income could throw your retirement plans into disarray – unless you have a plan B, such as having adequate cash savings to tide you over until things recover or working in some capacity.

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But now that drawdown has become the preferred choice, lifestyling’s place in the asset allocation discussion has become questionable.

And, like Vanguard’s Target Retirement Funds, a further sticking point is the lack of personalisation and agility to adapt to broader market conditions – a flaw that was exposed by the bond market woes a couple of years ago.

We must also note that there’s no guarantee annuities will be attractive at the point you wish to buy one. In response to interest rates hikes, annuity rates leapt 50%. This worked out well for those looking to secure a guaranteed retirement income, but in the previous decade and a half rates were paltry.

If annuities offer poor value in the year you plan to stop working, you might decide that drawdown, at least for the near future, is a better option. Lifestyle strategies take no account of such a pivotal change in circumstances.

Should you adopt your own de-risking strategy?

If you have the confidence to make your own investment decisions and manage asset allocations over time, then a manual approach might stand you in better stead. The upshot is that it enables you to tailor asset allocations over time to complement your personal circumstances, attitude to risk and specific goals.

You just need to have the time, inclination and nous to keep on top of things. This shouldn’t pose a problem for engaged and experienced investors.

A further advantage is that you can adapt your strategy periodically to reflect market changes – something not afforded by lifestyling or target retirement funds.

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Clearly, this approach isn’t for everyone; it’s very hands on, and you’ll need a firm grasp of what you’re doing. But other than paying for regulated financial advice, it’s the most effective way to employ a de-risking strategy that’s tailored to what you’re personally trying to achieve.

And it doesn’t have to complicated. For investors who opt for Vanguard LifeStrategy as a core holding, you could simply switch to a lower equity weighted fund over time. For example, moving from Vanguard LifeStrategy 100% Equity or 80% Equity into either the 60% Equity, 40% Equity, or 20% Equity fund can be a way to de-risk gradually while keeping you in control.

Do you even need to de-risk your pension?

While some degree of de-risking will suit many investors, it’s not that cut and dried. In some instances, it can make sense to leave things as they are and plough on with same strategy.

For example, if you’ll have other income streams in later life, such as a defined benefit (DB) pension or property rentals, then reducing portfolio risk within your defined contribution (DC) pot might not be necessary. Unless you need replacement income the second you pack up work, you can delay accessing your savings until the time is ripe.

An alternative is to continue with your tried-and-tested investment strategy, but simply make sure you have a sufficient cash buffer to dip into temporarily to avoid encashing shares when markets are experiencing a rough patch. This could be either inside or outside your pension.

Whatever method you feel is right for you, the key message here is to frequently check your portfolio against your goals.

Pinning your hopes on a ready-made de-risking solution may result in disappointment if the pieces of your own retirement puzzle experience subtle or dramatic changes, which is often what happens over time.