Wake-up call

They seemed like a good idea at the time. But lifestyle funds, which automatically move pension investors into less risky asset classes as they close in on retirement, could do serious damage to the standard of living of hundreds of thousands of people in later life.

The argument for lifestyle funds was they would protect savers in the final few years before they used their pension pots to buy an annuity income. Such savers could not afford to have their pension funds plummet in value shortly before the moment of annuity purchase, but often did not proactively move into less volatile assets in order to protect themselves. An automatic switch therefore made sense.

Today, however, far fewer pension savers buy an annuity. Since the pension freedom reforms of 2015, it has been much easier to simply withdraw pension income direct from your fund, leaving it invested to produce more income in the future. Unfortunately, savers and their advisers do not appear to have spotted the implication of this; by some estimates, there are still 850,000 pension savers invested in lifestyle funds programmed to move them out of asset classes with the potential to deliver superior returns, even though they may no longer need to reduce risk in this way.

In most cases, these savers would be far better off, over the long term, by sticking largely with stock market investments that offer the prospect of capital growth and ongoing dividend income. This is how they will ensure their pension funds can sustain them throughout their retirement, now they are no longer buying a guaranteed lifetime income through an annuity.

This is not to say investors should simply leave their pension fund holdings untouched as they move into later life. What they need at this stage are funds with both growth potential and dependable income – that may not be the current tenor of their portfolios.

In which case, step forward investment companies, which have a far greater role to play in this new world of income drawdown from pension funds.

In part, that is because investment companies have a genuine track record of outperforming the other types of collective investment vehicle to which pension savers have access. In comparisons of investment companies investing in the same assets and markets as their open-ended counterparts, the former have very often returned substantially more.

However, it’s on income where investment companies really come into their own as a pension fund holding for later life. Unlike any other type of fund, investment companies are allowed to retain some of the income they earn on their portfolios in order to sustain pay-outs to investors in leaner years. The result is a far smoother profile of income distributions, often increasing every year through good times and bad. This is exactly what retired savers dependent on their pension funds for the majority of their income need most.

We should also add in the fact that investment companies offer access to a broader range of asset classes than other types of fund, particularly in illiquid areas such as private equity and property. This can be an excellent way for older savers to build some diversification into their portfolios – and to provide access to other dependable sources of income; infrastructure funds, for example, offer many benefits in this regard.

For the moment, however, too many pension savers are stuck in those out-of-date lifestyle funds. We need a wake-up call – advisers and other pensions experts need to get people out before it’s too late.