One of the central tenets of retirement planning theory has been ‘lifestyling’. This is where your asset allocation is automatically shifted away from higher risk investments towards bonds and cash as you approach a set retirement date.

Lifestyling is based on a world where most people turned their defined contribution savings into a guaranteed income stream by buying an annuity. Nowadays, most people choose to stay invested in the market at retirement.

Annuities are still important, despite this shifting landscape, as around 80,000 of such products are sold by the insurance industry each year.

Lifestyling might well provide adequate protection against the downside risk associated with stock market investing. But whether this approach is appropriate for the majority is now open to serious challenge.

Understanding the spread of risks

A recent paper published by 7IM – essential reading for anyone looking to familiarise themselves with the debate – argues that investment risk is often given too much weighting versus other retirement risks.

These include:

• Savings risk – the risk someone doesn’t put enough to one side while working to fund their retirement

• Longevity risk – the risk someone outlives their savings

• Inflation risk – the risk that rising prices erodes the real value of accumulated savings

• Event risk – the risk a saver’s plans are hit by an unexpected life event, such as divorce or illness

The 7IM paper argues that for many retirement investors, lifestyling is no longer appropriate.

Taking investment risk off the table as you get older reduces potential stock market returns, just as your pot is reaching a size where equity exposure could make the biggest difference.

7IM points to academic research from the US which suggests INCREASING equity exposure over time – essentially the reverse of the ‘hold your age in bonds’ maxim – delivered the best outcome over a 30 year period.

However, taking lots of risk isn’t for everyone and if you are going to follow this approach, you need to remember that the value of your pot can go down as well as up – particularly in the short-term.

Is there another option?

One alternative is to look at ‘dynamic lifestyling’. This allows the portfolio mix to shift depending on the prevailing market condition, whereas asset allocation changes are often pre-determined with traditional lifestyling.

One dynamic strategy might involve a portion of the client’s portfolio – say 20% – invested in a dynamic fund which makes unconstrained asset allocation decisions. The remaining 80% would go into a traditional, deterministic lifestyle fund.

Another version is 100% dynamic, but within certain set parameters. So if, for example, the deterministic lifestyle strategy puts the emerging equities allocation at 6%, the dynamic lifestyle strategy could have the flexibility to alter this to anywhere from 3% to 9%.

Tom Selby,

Senior Analyst, AJ Bell

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