Should the proposed auto-enrolment scheme include lifestyling?

Homer

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Moved from another thread to highlight the issue - Brendan

Logic dictates that riskier assets should offer higher expected returns, otherwise people will invest is less risky assets. Of course, market pricing is never perfect, so there will be variations around this central premise from time to time.

There was a reference in the "Cabinet Approves Auto-Enrolment" thread to pound cost averaging and how lifestyling is an extension of this principle. However, in today's pension environment, it is extremely unlikely that anyone will end up purchasing an annuity, so the idea of managing risk relative to a specific date in the future is not really valid. Pension fund investment nowadays should instead be regarded as a continuum consisting of a period of accumulation followed by a period of decumulation.

This is a gradual process and retirement, or from an investment perspective, switching from accumulation to decumulation does not, in my opinion, represent a significant step change that would justify a corresponding step change in investment strategy. It could be argued that it would be appropriate to aim to have 25% of the fund in relatively low risk assets in order to protect the tax free lump sum, but I see this as being fairly ineffective and relatively unnecessary for the following reasons.

It's ineffective because all you're doing is reducing the potential volatility in the tax free lump sum by 25%. It's not possible to split a pension fund into two parts, with one part earmarked for the lump sum and the other for continuing investment in an ARF or similar. Therefore, if you put 25% of the fund in cash and 75% in return seeking assets (presumably primarily equities) and there is a fall of 20% in these return seeking assets, your overall fund will have fallen by 15% and your tax free lump sum by the same percentage.

It's unnecessary unless you plan to spend most or all of your lump sum immediately on retirement e.g. to purchase a property or pay off a mortgage/other debts. Any balance you are not planning to use immediately will need to be invested and the way in which it should be invested is subject to the same basic issues as apply to the investment of your ARF, with maybe some adjustment for the different tax treatment of pension fund and non pension fund assets.

Which gets back to my earlier comment about pension fund investment being a continuum. My own view (and I accept that this is just a personal opinion) is that there should be some form of gradual derisking over time, with 100% or thereabouts in return seeking assets early on in the investment cycle (particularly as, at that stage, the bulk of your prospective pension fund will be derived from future contributions) and some switching to less 'risky' assets on a phased basis as you get older. In some cases, this might even lead to using some or all of your ARF assets to purchase an annuity if you reach an advanced age and are still in reasonably robust health.

Part of the above process would mean deciding on an appropriate investment strategy for the years immediately following your retirement and any lifestyling/de-risking in the years leading up your retirement should be based on this planned post retirement strategy.

I'd welcome people's thoughts on the above. As someone whose pension assets are mainly invested in an ARF, it is a subject that is quite close to my heart and I find myself constantly struggling to avoid the temptation to try to 'time' the market by making short term tactical changes in my investment strategy.
 
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Excellent post Homer,

Time, regrettably, does not permit me to write a detailed response.

Just two comments.

1. I think Brendan's point was that the terms lifestyle and DCA just kinda sound good - but that when you gawk under the bonnet, there ain't much really there.....(as opposed to one being an extension of d'other). Incidentally, I broadly agree with Brendan 're DCA and completely disagree 're lifestyling.

2. As you correctly point out, the key consideration in the design of lifestyling - particularly in the lead up to retirement age - is to position the fund so that it best accommodates the most likely post-retirement application of the money. For example, the old school idea of transitioning a substantial portion to long-dated bonds would be very silly indeed in the current climate.
 
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@Homer You're right that de-risking in the run-up to retirement is economically wrong, arguably even for the 25% tax-free cash. I go further: in an ideal world ruled by homo economicus (and femina economica), there would be no de-risking at any time, before or after retirement. Unfortunately, some can't take the psychological pain of the volatility associated with high levels of equity investment, but spreading the ups and downs of investment returns across different years and different generations of contributors makes it a realistic option for all, in both economic and psychological terms.

De-risking is to consciously reduce the expected return on the fund. The expected reduction for a purely bond based fund compared to a purely equity-based fund is around 4% a year (some would say it's greater). In terms of expected returns, it has much the same effect as an increased management charge. Tell someone that there's a 4% higher management charge in a bond or cash fund than in a purely equity-based fund and they would change their tune about de-risking double quick.
 
I was talking to Brendan last Friday about the likelihood of a market correction, given recent strong returns. My gut told me that it would be a good time to de-risk, but we both agreed that the problem with this is knowing when to get back in. So I'm going to ride out the storm, unless I lose my nerve.

I know this is a bit off topic, but it ties back into my earlier comment about struggling to avoid the temptation to try to 'time' the market by making short term tactical changes in my investment strategy.

Maybe this should be dealt with as a separate topic, but I would welcome any thoughts/observations/suggestions.
 
I read a recent piece about DB funds and how “regulators” effectively forced them to “de-risk” significantly out of Equities and into Bonds over recent years. The effect was that DB “deficits” increased over the last few years whilst at the same time Equities performed very well.
With Bond yields so low (and unlikely/unable to go any lower), any increase in interest rates will result in Bonds losing capital value and increasing DB deficits further.
De-risking in the case of individuals can be sensible (at least to reduce the psychological pain), because individuals have a limited time horizon and no/ little opportunity to make up for losses. But DB schemes are not so restricted and can/must take a longer term perspective.
 
I read a recent piece about DB funds and how “regulators” effectively forced them to “de-risk” significantly out of Equities and into Bonds over recent years.
Conan. You're right. DB pension schemes promise a specified income for the retired member's life. The regulator rightly asks them to treat that promise as a guarantee, and therefore to invest accordingly. Benefits to contributors under the proposed auto-enrolment pension scheme will not be guaranteed, so the same investment constraint doesn't apply.

At a macro level, the AE scheme can be viewed as a sovereign wealth fund (think Norway), with contributors having a share in the fund based on how much they've contributed and for how long. No-one would suggest that Norway should invest a portion of its wealth fund in bonds delivering zero or negative returns. Instead, it puts in money in real assets, including a fair dollop in unquoted investments, that should grow in value in the long-term. The same should apply for our national auto-enrolment scheme.

Market values of the scheme's assets will fluctuate, but the scheme will have positive cash flows for decades and there will be no need to sell assets to meet payments to retired members, so market values are largely irrelevant. Market values will matter ultimately of course, but they needn't be a god to be adored at all times. Individual members' entitlements should be determined by spreading gains and losses (mostly unrealised of course) in a manner that reduces the volatility of short-term fluctuations in market values. That's effectively what I'm proposing with the smoothed approach.
 
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The Norwegian Sovereign Wealth Fund invests around 30% of its assets in bonds, many of which currently have negative yields.

Leaving that aside, I would have no problem with the re-establishment of our National Pension Reserve Fund, with contributors having a direct share in the fund.

People can reasonably disagree about the precise asset allocation but the allocation used by Norwegian Sovereign Wealth Fund would certainly be a useful precedent.
 
The Norwegian Sovereign Wealth Fund invests around 30% of its assets in bonds, many of which currently have negative yields.
Sorry! I take your word for it. I should have checked first. I think we agree on the principle
 
Revisiting this thread. Yes the Norwegian fund currently has €600bn kroner (€60bn) in bonds earning negative yields. I think there is a statutory cap of 70% in equities and I am unsure whether there is political pressure to change that given the current valuation of bonds. Perhaps our Penion Reserve Fund was a better guide since I don’t think it had any statutory constraints.
I read again Homer’s excellent OP. It now occurs to me that the 25% TFLS is almost completely irrelevant. Imagine that 100% could be taken tax free at retirement, surely that would not dictate targeting 100% cash at retirement. What matters are your holistic cash flow requirements. True the act of retirement and possibly the TFLS might make you think having a celebratory world cruise but otherwise it is as Homer observes merely a date in the continuum.
 
Perhaps our Penion Reserve Fund was a better guide since I don’t think it had any statutory constraints.
When the NPRF was set up back in 2001, its Board decided to allocate 80% of its assets to equities and other real assets and 20% to bonds. However, at that time it was not envisaged that there would be anything drawn from the fund before 2025 so it had a pretty long investment horizon.
 
When the NPRF was set up back in 2001, its Board decided to allocate 80% of its assets to equities and other real assets and 20% to bonds. However, at that time it was not envisaged that there would be anything drawn from the fund before 2025 so it had a pretty long investment horizon.
Also bonds had a credible role in those days. For the life of me I can see no role for negative yields in retirement funding.
 
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