No guarantees

Lifestyling strategies may not be the best solution to de-risking money purchase pensions in the years before retirement says John Lawson, head of pensions policy at Standard Life

Sell in May and go away; don’t come back till St Leger’s Day. So goes the adage about timing your exit from and entry to the stock market.

In fact, it might have once again served its followers well. The FTSE 100 closed at 5,416 on September 12, the day before St Leger’s Day, which is the second Saturday in September. Those selling on May 19 would have seen the FTSE 100 close at 6,376 – some 18 per cent higher.

May 19 now seems like an age ago. Since then, the banking system reached and has come back from the brink of collapse, and the recession has driven the FTSE further down to less than 3,900 at the time of writing.

Those with a money purchase pension reaching retirement in October may well look back in envy at those who retired in May. Particularly if their retirement fund remains invested in an equity or managed fund.

Lifestyle or target-dated funds take the timing decision out of the equation. By switching investments from more adventurous funds to less volatile assets such as government bonds and cash in the five to 10 years before retirement, the fund is protected from sharp falls in equity markets just before retirement.

Lifestyle has become the most popular default fund for money purchase pensions over the last 10 or so years. My initial reaction is thank goodness that many people approaching retirement now are in lifestyle funds.

But lifestyle funds also have their drawbacks. Switching out of equities at the bottom of the market is not usually the best idea. And, although only 20 per cent might be switched out on any one given date, what if the market remains close to bottom for a year or two years? In that case, 40 per cent or 60 per cent might be switched out close to bottom.

Take someone in a lifestyle fund retiring on October 24 this year. Let’s assume they were invested 100 per cent in the FTSE 100 and switched out in annual 20 per cent tranches starting on October 24, 2003 and ending on October 24, 2007.

The average index value of the FTSE 100 on the five sell dates was 5,334. At least that is better than 3,900, but we could have done a lot better by staying invested in equities and selling almost any time between St Leger Day 2006 and May 2008.

Like those in 2003, people about to start the switching phase of lifestyle today might find that their first one or two switches take them out of an equity fund or one with large equity content at or close to the bottom of the equity market.

Is it time that we examined other default options as an alternative to lifestyle? It is unlikely that the previous oft-used default of with-profits will have delivered a superior end-result compared to a lifestyle strategy. Add in the inflexibility that exit in turbulent conditions is only penalty free on the selected retirement date, and it is clear that this is no panacea either.

What would be really useful is a fund that stays invested in equities but banks the winnings once a year. That way our FTSE 100 fund would have locked in somewhere well north of 6,000.

This sort of pre-retirement guarantee would also suit those who intend to move into income drawdown or guaranteed income drawdown after retirement. What is the point of switching out of equity-based funds into bonds and cash when you intend to stay in equities post-retirement?

The difficulty with funds that lock in (or ratchet up) the base value is that you have to switch the guarantee on in the first place. Should this happen automatically, as is the case with lifestyle? Or should it be done manually when the scheme member is reasonably sure of their retirement date? And what happens if you forget to switch it on?

Another complaint might arise around the cost of the guarantee. There are many who complain about the price of financial guarantees without considering their value. If the alternative to investing in equities without bearing downside risk is investing in gilts, then surely the argument must revolve around whether the higher price attached to the equity guarantee eats up the advantage? In this case, does the guarantee cost displace the equity-risk premium?

It will be interesting to see what the fashion in default funds is in five year’s time. Personal accounts might help answer this question with a consultation on investments imminent.

Retiring and selling in May 2008 looks like a good move with the benefit of hindsight. But perhaps this year, the second part of the saying was referring to St Leger Day 2009. Or even 2010.