What lifestyle choice

Lifestyling is under the magnifying glass like never before. Today\'s extreme market conditions, that have seen a collapse in risk asset values and soaring gilt prices, are bringing into question its status as the \'safest option\'.

The unprecedented volatility of the last 18 months has undoubtedly created clear groups of winners and losers. Investors who were in lifestyling funds and are retiring now will have done well out of it, locking in stockmarket gains and enjoying the sharp rally in gilt prices.

On the flipside, those now approaching retirement face the harsh reality of crystallising equity losses and buying government bonds at historic highs.

The potential creation of such distinct strata of pension haves and have-nots among those retiring so few years apart is redolent of with-profits and begs the question of whether the way we manage risk in the lead up to retirement needs to be reconsidered in light of the credit crunch. (See box below)

“I think that at the end of the credit crunch the industry will take a long, hard look at lifestyling and ask if we could do better,” says Adrian Boulding, wealth policy director at Legal & General. “Lifestyling goes some way to protecting you against market falls because you are switching over a number of years, but we did not expect to see the level of intra-day volatility that we have in this downturn.”

Lifestyling funds are the most popular fund choice among defined contribution scheme members, and now make up over two-thirds of default funds, according to the National Association of Pension Funds. Effectively a replacement for traditional with-profits and balanced managed funds and driven in the main by stakeholder and the move away from trust-based schemes, they have for some years been seen as the safest option where members are not receiving individual advice.

Not even the life companies that offer them pretend they are a perfect solution, but whereas past questioning of their effectiveness largely centred upon their suitability in an age of increased retirement flexibility, the past two years have served to underline the dangers of their approach to investment.

Different insurers use different methodologies in terms of duration, assets held and how regularly they are rotated. Although these can be tailored by employee benefits consultants the majority still rely on stepped blanket switching between asset classes.

The core lifestyling propositions from L&G, Standard Life and Scottish Life, for example, run over five years, typically moving 20 per cent of the fund down from equities into cash and gilts each year through a large programmed trade.

However, Boulding suggests one possible outcome of the credit crunch is the development of a “second generation” of lifestyling programmes that will switch assets more regularly with the aim of providing a better smoothing of returns.

He says: “More frequent but smaller switches, such as moving 5 per cent of the fund four times a year, should provide greater protection against day to day volatility.”

John Lawson, head of pensions policy at Standard Life, says that given the mechanised nature of the process this could easily be done on a monthly basis and act as a reverse drip-feed.

“Once a year can be quite spiky and switching more regularly would theoretically smooth returns and provide a better reflection of how the market has done over that period,” he says.

“It is effectively the opposite of pound-cost averaging. There is a concern about when you do this though, because seasonal factors can have an impact on the market.”

Standard Life favours running a lifestyling programme over five to seven years, which it believes best positions it to capture the returns over an economic cycle.

Indeed, the issue of term remains hotly debated and the fact that the MSCI World Index is down -2.72 per cent over the 10 years to 9 February has blown a hole in the argument that six or seven years is a ‘safe’ investment horizon for equities.

In fairness to the insurers, there have been genuine attempts at driving innovation in the field of lifestyling. Scottish Widows and Scottish Life have either relaunched existing plans or launched new offerings.

A notable feature is that the two firms both opted for longer terms with Widows’ lifestyling running over 15 years and ScotLife’s over 10 years, which is a little bizarre as both developed their ranges with actuaries’ Barrie & Hibbert.

ScotLife’s new Governed fund range is effectively a contract-based arrangement that seeks to offer the benefits of a trustee-based arrangement. (See box above). It does this by affording Royal London’s chief investment officer Robert Talbot the flexibility to tweak the asset allocation and timing of switches within its lifestyling arrangement to try and maximise returns.

“The benefits of trusteeship are particularly resonant right now but this is intended to meet the needs of the members over the long-term too,” says Alasdair Buchanan, group head of communications at Scottish Life. “There is a tactical overlay that gives us a small amount of scope to move a little bit away from the benchmark where there are tactical opportunities to get better returns.”

The range has access to some 80 funds from 18 different asset managers making it one of the most flexible arrangements in the market.

Widows relaunched its lifestyling arrangement two years ago. Head of scheme acceptance Ann Flynn says the benefits of a longer approach are now more apparent and the back-testing they carried revealed the amount of potential upside lost is “not meaningful”.

It also has the flexibility to tweak asset allocation and rebalances quarterly to ensure it remains on target.

“As part of our governance we review the underlying assets and term annually and if we get to the point where we believe that 15 years or the current asset mix is not the best we will adjust the fund to reflect that,” Flynn says.

Not all are in favour of a flexible approach to lifestyling and Standard Life actually rejected the idea. Lawson explains that the risk of making the wrong call could be disastrous to pension savers, the majority of who are looking to remove choice from the equation.

Putting the ideas that could help future generations to one side, the fact remains that a legion of individuals facing retirement have just seen a significant chunk of their pension pots disappear and need to decide whether lifestyling is still the best option for them.

The all or nothing strategy is clearly a tough call and at the heart of the problem once more is the fact that many of the individuals worst affected will neither be willing or able to pay for individual advice.

“For some people it is no doubt worth doing but as soon as you go down that route you need regular reviews and there is a cost attached to that,” says Buchanan.

Whether the individual is in income drawdown is a key determinant, Boulding says, noting that they can still maintain exposure to the market in an effort to recoup some of their losses.

The idea that all people in income drawdown are wealthy enough to withstand the pain of the last 18 months is something of a broad generalisation.

Mike Gough, executive director at Jelf, likens the current situation to back in 2001-2002 when many people had seen their investments decimated by the tech bubble bursting.

He says: “It was pretty awful, particularly for people in income drawdown who had seen their funds fall very sharply and annuity rates fall by a third at the same time.”

“Some of them increased their equity exposure but there is much more fear now. If you have a five year outlook there is a logical argument to be higher in equities and we are having those conversations.”

The key thing is to ensure clients understand the risks involved and that the decision process is taken jointly. As a discipline he chides clients who congratulate him on picking a fund that has risen reminding them that that decision was taken together. The need for the management of client expectations on the downside is even more pronounced but undoubtedly some people will have little choice but to bite the bullet if they are to have any hope of recovering from this most extraordinary sequence of events in the market.

The potential lifestyling timebomb

Tom McPhail, head of pension research, Hargreaves Lansdown

As many as 3 million pension savers over 50 face the difficult choice of how to tailor their investment strategy to meet their retirement needs, according to research by Hargreaves Lansdown.

The majority will inevitably fall into lifestyling but Hargreaves’ head of pension research Tom McPhail says that entering into lifestyling now runs the risk of selling equities at multi-year lows and buying gilts at historically high prices. He says that while a good actively managed strategy is preferable, simply holding a balanced managed fund would have provided a better pension two thirds of the time since 1978.

McPhail says that in the 26 five year periods analysed, balanced managed funds outperformed on 18 occasions and on average by £25,369. In the 8 occasions when lifestyling prevailed, it did so by just £15,501 on average.

Playing the percentages on this basis would therefore lead investors away from lifestyling. However, the lifestyling fund never lost money over the periods measured unlike balanced managed funds, which did between 1998-2003 and 1999-2004.

“The lifestyling strategy therefore narrows the range of returns, meaning your worst returns are not as bad as those from a balanced managed fund. However, in exchange you often miss out on much of the upside produced by a balanced managed fund,” he notes.

It is therefore necessary to decide whether the frequency and magnitude of balanced managed funds’ outperformance is worth the risk of a worse outcome. The decision is not easy, particularly when you factor in lifestyling funds’ potential as a partial gilt hedge too, but the unfortunate truth is that most investors will not even contemplate an alternative to lifestyling despite the potential rewards.

The move away from trust-based schemes

Alisdair Buchanan, Group Head of Communications, Scottish Life

More than two thirds of companies say that given the choice of starting from scratch, they would opt for a contract-based defined contribution arrangement, according to Buck Consultants’ latest pension survey.

In many ways this figure is not surprising due to the increased management input and higher levels of costs associated with running trust-based schemes.

The National Association of Pension Funds’ 2008 annual survey found that the average cost of trustee training had soared by 25 per cent to £60,300 year on year.

The same research also found that 20 per cent of trustees had resigned that year and a further 40 per cent, including independent trustees, are considering doing so reflecting a lack of appetite on both sides.

With contract-based arrangements likely to increase their dominance the issues of default funds and lifestyling are set to remain a hot topic.

The NAPF survey also found that 84 per cent of schemes offer a default with 91 per cent of their members invested in it.

Scottish Life group head of communications Alasdair Buchanan says that with so many future retirees set to be reliant on lifestyling programmes it is important that the industry comes up with more innovative and flexible solutions.

He adds: “The Pensions Regulator has talked about the dangers of losing that governance element as employers move from trust to contract-based schemes and the Governed range is an example of how we are looking to address that risk.”