Investors warned over ‘lifestyle’ funds

People with company pension schemes are being warned to be careful of “lifestyling” strategies – which could see their savings moved into the wrong place at the wrong time.

Wealthier investors who are likely to keep their pension invested in the stock market when they retire – rather than buy an annuity – are at particular risk, according to consultants.

Lifestyling is a feature of defined contribution (DC) pensions. Under a DC scheme, employees pick a pension fund for their savings, then use it to buy an annuity or move into income drawdown when they retire.

If the fund uses lifestyling – not all do – the pension assets are moved out of equities and into “safer” investments such as government bonds and cash as
the investor approaches
retirement.

Assets are moved in this way for two reasons. One is to prevent people who are about to retire from losing large amounts of their pension savings in a stock market crash.

The other is to try to match the value of the assets to annuity rates. Annuity rates are usually calculated using the yields on gilts, so if the price of gilts falls in the pension, this will be compensated for by higher rates on an annuity – in theory offering more protection against value losses.

Lifestyling is typically aimed at people who do not take much of an interest in their pension. It is applied on most default funds in company pensions – the funds that members are put into if they make no other choice.

But default schemes are far more widespread than many may realise. Recent research by Aon Consulting found that 80 per cent of investors in most company pension schemes are in the default fund.

However, lifestyling is increasingly being viewed as a rather blunt instrument.

“There are significant shortcomings in the way lifestyling works today in the market,” says Julian Webb, head of DC at Fidelity International.

“Lifestyling is quite a blunt tool,” agrees Brian Henderson, a consultant at Mercer. “It’s set up to match an annuity at the point of retirement – it’s not trying to cater for all the sophisticated investors out there.”

The theory behind lifestyling involves two important assumptions. The first is that gilts are always less risky than equities.

Proponents of this view point out that many DC members who had been moved into fixed interest and cash during the credit crunch escaped the falls in the stock market that prevented other less fortunate investors from retiring when they had planned.

“When lifestyling was meant to work, it did – it protected people against the crash,” argues Henderson.

But there may be trouble ahead for people about to move into lifestyling. Many experts are predicting that inflation will be a problem again within the next few years. Inflation is usually a bad time to buy gilts, as prices fall to push yields up to a high enough level for income investors.

Mark Dampier, head of research at Hargreaves Lansdown, says this could mean that, far from derisking people’s portfolios, investors will be buying the wrong assets at the wrong time. Lifestyling is done through an automatic computer process and involves no active fund management.

“These things [lifestyled pensions] are going to be a time bomb in a few years,” he warns.

The second assumption is that investors will buy an annuity with their pension funds. But while this is the case for the majority of retirees, it is not true for everyone. People who intend to leave their funds invested in the stock market at retirement and draw an income from them could be surprised to find they have been shifted into gilts and cash instead.

Some pension consultants are recognising the drawbacks of lifestyling and are devising new approaches. Fidelity is trying to convince pension scheme trustees to use a multi-asset fund instead of a global equity fund, which would be run by an active manager who would decide the best times to buy certain asset classes, rather than leave it to a computer.

Webb admits that this is likely to cost more – multi-asset funds typically have higher management fees than plain equity funds – but he argues that fee “sensitivity” should not necessarily be the main concern. The desire to cut costs led
a lot of other schemes to opt for global equity passive strategies – which simply followed the stock market down in the past couple
of years.

Investors who are concerned about lifestyling should check whether it applies on their funds.

Jesal Mistry, a consultant at Aon Consulting, says there is a good range of funds at most DC schemes, giving members who would prefer not to buy an annuity a decent choice.