How to change your investment strategy in retirement

For decades, retirement planning followed a relatively simple formula. Build up a pension, stop working and rely on the income it provides.

But retirements are becoming longer, and fewer people are taking the path of a guaranteed annual income, choosing to manage their own retirement funds instead. This flexibility can allow for freedom in retirement, allowing you to, for example, take a big holiday in the early part of your retirement or opting to pay off your mortgage. But it also means that planning increasingly involves combining several income sources while managing the risks that come with drawing money from investments.

For most people, this means a switch in investment strategies as they enter the drawdown phase.

Retirement now comes with more options

Many retirees now use a combination of income sources to fund their lifestyle rather than relying on a single solution.

Guaranteed income from the state pension, an annuity or a defined benefit pension may provide the starting point. This can be supplemented by rental income, part-time work or withdrawals from defined contribution pensions, ISAs and other tax wrappers.

The right balance depends on personal circumstances, but many prefer to use their guaranteed income to help cover essential spending, investments like other pensions and ISAs for flexibility and growth potential, and supplementary earnings to reduce the strain on savings.

What risks do retirees face?

Two risks are particularly relevant once withdrawals begin: longevity risk and sequencing risk.

Longevity risk is the possibility of outliving your savings. As life expectancy increases, many retirees may need their assets to support several decades of spending.

Sequencing risk is the damage caused by poor investment returns early in retirement, when withdrawals are already being taken. Selling assets during a downturn leaves less capital to benefit from any later recovery.

The order of returns matters

Many people will view their investment returns on an average basis over many years. But it’s important to understand what returns in individual years could mean for your ability to take income along the way and the final value of your pension pot.

Here’s how two portfolios delivering the same average return, but with different returns on a yearly basis, can differ significantly after 30 years.

At one stage, the difference between the two portfolios exceeds £36,000 on an initial investment of £25,000, despite reaching the same endpoint after three decades. When you are building the value of your pension, these sequencing differences become irrelevant because you end up with the same value pot. But once you reach retirement, and start making withdrawals, those differences become much more significant and lead to very different final pension pot values.

In this simulation, two £250,000 portfolios each achieved the same 5% average annual return. Both made annual withdrawals equal to 5% of the initial capital, uplifted by 2.5% inflation. One portfolio exhausted its assets after 30 years, while the other still held more than £92,000 after facilitating cumulative withdrawals of more than £523,000.

The sequence of returns, rather than the average return alone, drove the result.

The role of multi-asset investing

This sequencing difference is why portfolio construction matters so much once a pension pot is being used to fund regular withdrawals.

Retirement investing must balance growth, risk control and the need for dependable cashflow.

Multi-asset investing combines asset classes that behave differently under varying market conditions. Equities provide growth potential and can help preserve purchasing power over the long term, while bonds and cash can help dampen volatility and provide a source of stability during periods of market stress.

• Read: What AJ Bell DIY investors are holding in their SIPPs

Blending these assets can reduce the extremes of portfolio performance, therefore minimising sequencing risk, while retaining exposure to long-term growth. The aim is a portfolio that can cope with changing market conditions and continue supporting withdrawals through retirement.

Income matters, but so does cash flow

Generating income is only part of the challenge. The timing of that income also matters.

Most household bills arrive monthly, yet many investment funds distribute income quarterly or half-yearly. According to our data, around 70% of income funds pay income twice a year, while just over 10% distribute income monthly.

That can make budgeting harder for investors who rely on portfolio income to meet regular expenses.

The AJ Bell Income Fund and AJ Bell Income & Growth Fund aim to address this through diversified multi-asset portfolios targeting an average income yield of between 3% and 5% over a rolling three-year period, with income paid monthly.

It also includes a smoothing mechanism that aims to make 11 of the monthly payments more consistent, with the remaining income paid at the fund financial year end. Payments can still vary and are not guaranteed, but the approach is designed to support cashflow planning.

Looking beyond income

While income can become top of mind in retirement, any retirees will still need capital growth to ensure their pension lasts through their entire retirement.

Investors who reinvested distributions since the launch of the AJ Bell Income fund in 2019 achieved stronger overall returns than those who received the income. Those extra funds were able to create a larger pot to compound overtime, leaving them with more in the end.

Most of those in retirement will need to take some level of income, but even if just a portion can remain as growth in capital, it can help support future withdrawals and offset the impact of inflation over time. A longer, more flexible retirement requires a broader approach to income planning. Guaranteed income, investments and supplementary earnings can each play a role, while longevity and sequencing risk need to be managed carefully.

Used well, a diversified retirement toolkit can help align income, growth and risk management with the realities of later-life spending.