Lifestyle funds are a seductive solution to the demands of building and maintaining a retirement fund. The funds supposedly do all the thinking, moving into lower-risk assets as an investor nears retirement. However, there is a danger that high exposure to gilts could leave investors at this time of life vulnerable if the climate of low interest rates and quantitative easing starts to shift.
'Lifestyling' has become a popular option for defined-contribution pension schemes and is often the default option for scheme members. These funds often take a conventional asset allocation route, with younger investors largely exposed to equities, with older investors largely invested in developed-market government bonds - usually gilts.
To date, these funds have often worked well to compensate investors for lower annuity rates. Annuities are priced from the rates available on long-term gilts. As quantitative easing and low interest rates have suppressed gilt yields, annuity rates have fallen. At retirement, lifestyle funds are loaded up with 'low-risk' developed-market government bonds and investors have benefited from their rising capital values.
The issue is what happens next. Gilt markets have been distorted by government interventions. Yields are at historic lows and there is a risk of a sudden drop-off in capital values if any of the current mechanisms supporting the gilt market - quantitative easing or low interest rates, for example - were to end. Alistair Cunningham, financial planning director at Wingate Financial Planning, says: "Typical lifestyling in pensions leads to a 75 per cent gilt and 25 per cent cash blend. If interest rates leapt up and annuity rates improved the fully lifestyled fund would plummet - this may not be a problem for the income as the two factors should more or less compensate. However, the 25 per cent tax-free lump sum would be compromised as no protection applies - lifestyling aims to protect annuity purchasing power, not tax-free sums."
Laith Khalaf, pension investment manager at Hargreaves Lansdown, highlights other limitations with lifestyle funds. Notably, they work best with level annuities which pay a series of equal periodic payments for life, rather than index-linked annuities which rise in line with inflation or drawdown schemes from which the investor draws an income directly. Equally, Mr Khalaf suggests lifestyling only works if people are retiring at a 'conventional' age: "The fund will 'de-risk' at 60. Those who are able to retire early may find that they are still in risky assets, while those who retire later may find that move into low-risk assets too early."
The alternatives
There are alternatives. The first would be to select an alternative low-risk asset class fund. However, the climate of risk aversion since the credit crisis has left many 'low-risk' assets - such as other developed market bonds, or high-quality equities - looking relatively expensive. Robin Keyte, director at Keyte Chartered Financial Planners, says: "Cash funds are an alternative, although they will lose out against inflation and in some cases the annual return will not be enough to cover the fund charges, leading to a little capital erosion. At this point in time there are no easy answers and for some that are at or near the end of their lifestyle strategy cash may be less bad - I hesitate to say 'better' - than other options."
The second is to select a multi-asset fund, where, like lifestyle funds, the asset allocation is decided by a fund manager, but there is more flexibility in the choice of assets. Mr Khalaf says: "The question for investors is whether they can do better than the pure fixed-income approach in retirement used by lifestyle funds." He cites the Newton Real Return or Standard Life GARs funds as potential alternatives. These will not have a designated asset allocation, but aim to deliver a consistent absolute return every year with low volatility. He also likes the Jupiter Strategic bond fund. Although this has a pure fixed-income strategy, it can 'hide' in areas such as high-yield bonds, which would be much less exposed to interest rate rises. Mr Khalaf believes that no one fund is right in isolation, but these could offer the right solution when combined. Mr Cunningham says that the better with-profits funds may also offer an alternative, offering smoothing over a number of years and the offer of capital protection at normal retirement date.
What about those investors who have no choice but to use the lifestyle fund offered to them by their corporate scheme? Is it possible to counterbalance the weighting in government bonds with a high exposure to, say, equities, elsewhere in a portfolio? It does not avoid the de-risking conundrum, but at least a careful consideration of the overall weights in a portfolio can ensure that it is not all pointing in the same direction. Peter Maher, director, Smith & Williamson says investors may want to consider making regular monthly investments into the stock markets so they remain exposed to equities which, historically, have performed well.
Maintaining an appropriate overall asset allocation balance takes an expert eye and close monitoring and needs to take into account the likely time and method of retirement. Lifestyling can seem like an attractively simple solution, but there are no easy options.
