Adopting a Lifestyle Approach to Pensions
September 2009
HR & Recruitment Ireland
by Samantha McConnell, IFG Corporate Pensions
Published: 4 September 2009
Lifestyling sounds like something a life coach or style consultant would undertake for you at an appropriate fee and which could be quite painful and costly.
In the investment world however, Lifestyling has come to mean something quite different. In simple terms lifestyling refers to a process whereby an individual’s investments move from having mostly equity investments to mostly bond and cash investments as they approach retirement.
The primary reason for introducing a lifestyle approach to investment is to ensure that as someone nears retirement their pot of money is not fully exposed to any sudden falls in investment value. From a legislative perspective it also allows the Trustees to better meet their investment duties to members of defined contribution schemes, as the legislation states that the Trustees must seek to match the nature and duration of the liabilities of the scheme. By introducing a life styling option, Trustees are meeting this obligation.
The lifestyling offering is most usually the default investment option for a DC pension scheme. Trustees have an obligation to provide a default fund option where fund choice exists and that default option is used for all members who do not make a choice about where they want to invest. Research shows that the default option is chosen roughly 81% of time and as a result there is a huge onus on the Trustees to ensure that the default option is appropriately structured. The reasons for the high percentage of members investing in the default are twofold. They see the offering as having been endorsed by the Trustees as being the best investment option and for most members, investments and pensions can be a confusing topic and as a result they are willing to leave the investment decisions to the Trustees who they see as better placed to make them.
In practice there are two ways that lifestyling operates. One is where the fund manager has a number of funds and you are placed in the fund closest to your retirement date. The asset allocation, or where the assets are invested, of the fund then changes over time and particularly in the last 5/10 years. There are a number of these offerings available in the marketplace, from Hibernian, New Ireland and Irish Life to name but a few.
The other is where a third party administrator manages the asset allocation and then uses an underlying fund manager to manage the investments. This allows more flexibility in the choice of investment manager and can allow a more tailored asset allocation in the years coming up to retirement. Using this approach can also mean that member’s individual attitude to risk can be accommodated. Most lifestyling products assume that all people at the same age have the same risk profile; this is quite a simplistic approach. For example, you can have two individuals both working in the same company with very different outlooks on risk due to their personal circumstances. As a result of their differing outlook on risk, one may be more than happy to have all their money invested in equities while the other might prefer to have a lot of their money invested in less risky assets and be prepared to contribute more for that safety.
In order for lifestyling to work effectively, it needs to have a number of key criteria:
- high equity weighting in the early years,
- measured reduction in equity weighting from at least 10 years out from retirement,
- investments should be managed passively.
With the lifestyling approach to investment, there is a high equity weighting in the early years. Long term research shows that equities deliver real returns that are double that of bonds and cash meaning that your fund will grow at twice the rate that it would if you just invested in safe assets. As an investor, you have a choice; invest in bonds and over the longer term end up paying more money in to fund your retirement or invest in equities and over the long term end up contributing less. The key risk with equities as everyone knows is that they can experience falls in value like we have seen over the past two years. Now if these falls happen in the early years of your career you have a long time to make up the loss in value and again history shows that over a 30/40 year period this will happen. However, if these falls occur within a year or two of retirement, this is when it can really hurt.
The main rationale for a reduction in equities over time is to protect against sudden market movements. If you move all of your money out of equities say with five years to go, you are at risk that the market makes a sudden move in either direction and you could get badly hit. By moving a small amount of money out of the markets on a gradual basis you lessen the impact of market timing issues and market volatility.
We recommend the use of passive funds as part of a lifestyling offering. Passive funds track a market index. Unlike active managers they do not seek to outperform a market. So for example, if you invested in a passive fund that tracked the ISEQ it would deliver performance in line with the performance of the Irish market, nothing more nothing less. There are a number of advantages to this approach. First, the fund will never substantially underperform its benchmark. With a few notable exceptions, most active managers do not deliver out performance consistently over a 20/30 year period. By going passive, you eliminate the risk of underperformance. Also, most passive funds are substantially cheaper than their active counterparts. This is important as a reduction in cost by as little as 0.40% can add almost 14% to your annual pension if you transfer into a cost effective life styling option with 40 years to go.
Given the change in investment regulations and the more onerous responsibilities that are now placed on Trustees in this area, it makes good sense for the Trustees to adopt some form of lifestyling as their default investment offering. Our advice is to go for a passive lifestyling that allows caters for members’ attitude to risk and allows your members access to lower cost funds.
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