Inv-Retirement 4-Ian McKeeever & Co

The run up to Retirement
This section is for when retirement is less than ten years away. If it is further away it may still be worth reading but you will be reading ahead as it were. It is in any event worth reading the earlier pages on retirement.

Up until now you will have saved for a number of things such as houses, holidays, cars etc. These all have two things in common

1) They are relatively short-term objectives, in that you at least hope to make the expenditure within the next ten years.

2) The target involves spending a capital sum as a one off payment.

Although retirement may look similar, in that the target is to have a capital sum when you retire so that you can buy an annuity, but it isn't. In investment terms at retirement you are merely changing the fund manager to the insurer providing the annuity. That new fund manager will invest in matching investments, which are long term Gilts.

You can consider insurance as a gamble. If you take out term assurance you might bet £100 that you will die next year. Assuming the chance of that is a 1 in a thousand (i.e. you are young), if you win (i.e. die) you get back £100,000 and if you survive you get nothing. An annuitant might be thought of as having a portfolio of Gilts, who each year takes out his income for that year and gambles the rest that he will survive. If the chance of death is one in a hundred and there is a 100,000 worth of Gilts and the annuitant survives he will get back £101,000 worth of Gilts at the end of the year.

Of course real annuities are more complicated as there can be spouses pensions and guarantee periods but the description of the process is accurate. The insurer serves two functions in this model. The insurer is both fund manager and bookmaker.

As bookmaker insurers have been studying the odds for 300 years and so they know pretty well what the odds are next year. Just like bookmakers they know that some punters will win and some will lose. Like bookmakers they fix the odds so that in the long run the house wins. However there is one major difference with insurance, the odds are fixed for the term of the contract. In the case of an annuity that term is the life of the annuitant.

Insurers are sensible fund managers. The price they charge a 65-year-old will be the cost of buying a portfolio of Gilts, which will supply the correct income stream. That cost will depend on gilt yields at the time. If interest rates rise the cost will fall and if interest rates fall the cost will rise.

If your target is a specific level of income in retirement, that means that your target is to have the price of such a portfolio when you actually retire. The safest way to achieve that is to have such a portfolio already.

However, whatever your risk profile is, it is important that you are aware of what the minimum risk portfolio should look like if only in order that you are aware of how much risk you are taking at any one time.

Considering the main assets classes:-

Equities
Over the last century equities have outperformed every other asset class over any 20-year period according to a Barclays Capital survey of market performance since 1900. However the same is not true over shorter periods and in any event a number of economic changes have occurred over that period favouring equity investment. These economic changes could be reversed and although the statement is true, it does not guarantee that equities will outperform other asset classes over all future 20-year periods, particularly given recent events.

However, in general it is reasonable to expect that enhanced investment returns can be obtained by taking risks. The key word though is risk and so this means that most of the time you will win but sometimes you lose. The more often you take the risk the more likely you are to end up a winner overall. If you can only take the gamble a few times it could go either way. The closer to retirement you get the less time you have to make up for the bad years and so the less you can afford to have bad years.

Cash
If your target is to have this portfolio of Gilts to provide your target income, cash could be excellent investment if interest rates are going to rise. The market value of the gilt portfolio will fall and so a given amount of money will buy a bigger income. The problem is that one never actually knows that interest rates are going to rise. At any given time expert opinion is divided on the issue. Interest rates could fall. In that case you will find that the cost of the gilt portfolio will rise and so your fixed sum will buy a smaller income and not a larger one. Cash is in this situation a tactical option but it is a high risk one.

Gilts
A portfolio of long Gilts is the low risk option because that best matches the benefits you hope to receive and is similar to the portfolio the insurer would invest in if you bought an annuity.

What do you do?
In the run up to retirement it is wise to have some sort of basic investment strategy in mind. It should be designed to balance the desire to maximise returns with the need to minimise your loses

If you assume that equity type investments are likely to make the highest returns but are afraid of the risks, the sensible strategy must be to hold a proportion of your portfolio in equities but reduce that proportion steadily as retirement approaches. You could for example start ten years before retirement and each year move ten percent of your portfolio from equities into Gilts or into a mix if 75% Gilts and 25% cash ( as you will take a quarter in cash)

Whether it is the best strategy for you will depend on your own particular financial circumstances, and on your ability to accept risk. Other strategies may be perfectly valid.

That is not to say that you should necessarily follow the strategy blindly. After five years with your portfolio split 50:50 equities and Gilts you might take the view that equities are due for a run and not sell a fifth of your equity portfolio and put it into Gilts. You might do nothing. A year later according the strategy you should be going into this year with 70% in Gilts and 30% in equities. You might take the view that equity markets were high and gilt yields were likely to fall you could on the basis of your market view you are going to reduce the equity percentage to only 20% rather that 30%.

A strategy is just that. It is a standard that you might decide to deviate from for tactical reasons but you do need a strategy. If you have a positive view of equities and retirement is eight years away having 100% of the fund in equities might be reasonable but if retirement were only two years way having 40% of the fund in equities would be very risky. It is a matter of what the proportion is relative to the strategy.

Everyone is different and there is a danger in giving any advice of the basis that one size fits all. However the above strategy represents a reasonable baseline on which to base your own strategy. It is also worth reading comments on the current economic situation.