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Lifestyle for retirement
Chris Potts from the pensions administration department in Barnett Waddingham's Amersham office addresses the issues surrounding inclusion of lifestyle investment facilities.
Lifestyle strategy
With the increasing popularity of defined contribution pension schemes, the issues surrounding the inclusion of lifestyle investment facilities need addressing.
Lifestyling is a term given to a feature of defined contribution pension schemes which aims to deliver prudent investment choices for members. This facility provides pre-determined investment selection from a range of funds offered by the pension scheme trustees. It usually includes a series of future automated investment switches as the individual members approach their planned retirement date.
This method is unlikely to produce the maximum possible return on the contributions invested but instead aims achieve reasonable growth with a balance of safety and risk.
Lifestyling is often offered as a standard feature of "off-the-shelf" insured pension products such as personal pensions or stakeholder products. However, it is increasing in popularity in privately-run occupational pension schemes. The availability of automatic switches and direction of contributions to appropriate investments is seen as attractive for several reasons.
Choices, information and advice
A defined contribution scheme will typically offer three, or more, separate investment funds to the scheme members from a range pre-selected by the scheme trustees. These choices have been made from recommendations made by the trustees' professional investment advisers and, as such, are informed and prudent decisions. However, due to the legal regulation of investment advice, trustees are rarely authorised to give individual personal investment advice to the scheme members.
This is a legal minefield, especially as it is quite understandable that members, wishing to make prudent decisions themselves, approach the trustees for advice.
In these circumstances, the trustees should provide factual information, for example generic literature from the fund managers regarding the investment strategy of each fund and statistics on past performance. However, the member must make his own choice without advice from the trustees. Even here, trustees must be careful not to promote lifestyle above the free choice option by making the lifestyle approach the default investment, in case this is interpreted as advice.
Members need information in order to make investment choices. This can be an added expense to the trustees where drafting and production of additional communication materials is required. Alternatively, members could seek personal financial advice. Whichever option is preferred, someone has to pay.
A happy medium appears to be reached by providing a pre-packaged lifestyle option.
The lifestyling mechanism
For younger members, with longer periods to invest prior to retirement, investments are likely to be made into funds with higher potential for growth but with higher associated risk. These are usually equity-based funds. In later years, as members approach their planned retirement date, the lifestyling mechanism gradually moves investments into less risky investments, typically gilt and deposit-based, thus consolidating on earlier investment growth.
Typically, a lifestyle strategy has a minimum of three funds:
More funds may be used at intermediate steps in more complex strategies.
Ultimately, just before the member retires, it is common to aim for 75% in gilt investments and 25% in deposit investments. This reflects the investments associated with likely benefits to be provided from the pension scheme: typically 75% of a member's accumulated fund buys an annuity, which traditionally has underlying gilt investments, and 25% is taken as cash, matching the deposit investments.
A series of fund switches are made as the member approaches normal retirement date to gradually move investments from high risk to lower risk. This usually starts no more than 10 years before normal retirement date (NRD). Future contributions are also redirected to safer funds similar to the switching of accumulated funds. The contribution redirection usually mirrors the funds switches but different strategies for existing funds and future contributions are possible.
Table illustrating a simple lifestyle strategy:
Design features
Of course, the switching strategy could start at longer or shorter terms than 10 years. For example, a target retirement date earlier than NRD could be substituted into the table for an individual member who is targeting an earlier retirement.
As mentioned earlier, the member's accrued investment fund may be profiled differently to ongoing contributions. It is not always sensible to make continued payments to a higher risk fund and suffer charges to switch to those same payments a few months later. A common solution is to direct ongoing contributions to the lowest risk fund applicable to the member's position in the lifestyle table.
Similarly, fluctuations in the comparative performance of the funds in the strategy can result in rebalancing which would result in switching back into higher risk funds. This anomaly is often removed by not allowing "reverse switching" in the lifestyle design. There are arguments both for and against allowing reverse switching but the simple approach is not to allow it.
The frequency of switching is usually restricted to once a year and all members' funds are rebalanced together. This is usually the most cost-effective method as administration costs for lifestyle switching can be high if performed more frequently.
It is possible to make lifestyling the only investment facility within the scheme and not to give the members any choice on selecting any of the underlying funds individually. This may prove too restrictive for members who are more financially aware and this needs to be addressed in the design process. Trustees may compromise by allowing members to individually select funds for their personal contributions but to restrict employer contributions to the lifestyle route.
Planning for lifestyling
For a scheme member, lifestyling takes away a lot of worry and potential cost from seeking individual advice. Members should still review the performance and how the design of the investment strategies reflects their own retirement plans as their career advances.
Scheme trustees considering the inclusion of a lifestyle facility in their scheme design, should be encouraged to liaise closely with the key participants, in particular, the scheme administrators and investment managers, taking heed of their experiences and advice. Getting it right from the outset is very important as modifications to existing lifestyle strategies are complex and can be problematic.
I have touched on just a few of the design considerations above. A well thought out and implemented lifestyle design is the key to its success.
Chris Potts, May 2003.