There has been a lot of press coverage in recent weeks around the UK government’s borrowing costs and how a rise in gilt yields means it’s costing more to service our debt.
Whilst this has impact on the government’s spending plans and means less money for public services it can also negatively affect your pension, particularly if you are close to retirement.
We have been here before back in 2022, which culminated in the fallout from the Liz Truss and Kwasi Kwarteng ‘mini-budget’.
Some of you may have suffered the shock of seeing a large fall in the value of your pension around this time which would have rocked your retirement.
The bigger issue here is not successive government incompetence (that will likely continue and there is nothing we can do about that until we get decent politicians) but the investment strategy you are using for your pension.
Unfortunately, you have been given a rubbish pension investment product.
It’s important to learn the lessons quickly from 2022 to avoid a repeat.
It’s your pension investment strategy that is the problem
Auto-enrolment has largely been a success in ensuring that everyone that joins the workforce is set up with a workplace pension that both you and your employer pay into.
The problem with the workplace pension is that people still take little interest in what their pension money is invested into.
There’s a good chance that if left to your own devices you may never actually invest your workplace pension and the money could sit there in cash for the rest of your working life.
This of course would be disastrous as not only would your pension not receive any return, but the value of your contributions would also be eaten away by inflation.
So, in trying to be clever the pension industry came up with default/lifestyle funds.
These are the investment funds your pension money will likely automatically be placed into if you do not make your own choice.
The idea with default/lifestyle funds is that they automatically change the investment strategy you use as you approach retirement.
Whilst you are young and just starting out, you will be heavily invested in ‘growth’ assets like equities.
As you get to within a few years of retirement you will be more invested in ‘defensive’ assets like bonds.
The idea sounds good in theory. Protecting what you have built up in your pension pot, so it is ready for your retirement.
However, the concept has a number of flaws.
Firstly, the point at which changes are made to the investment strategy, moving from equities to bonds, is wholly dependent on what age you select for your retirement.
The younger you are the less likely you will know when you are going to retire.
Most people will select age 60 or 65 as their retirement. But if you don’t end up retiring until age 67 or 68 in line with your State Pension age then do you really want your pension sat in low growth assets for seven or eight years?
Secondly, even if you do retire exactly when you told your pension provider you would what are you planning to do with your pension funds.
The default/lifestyle concept was designed for people who want to purchase a pension annuity at retirement.
An annuity is where you use your pension funds to purchase a secure income for the rest of your life. You give up the pot in return for income. A decision which can’t be changed.
Of course, you want the maximum pension pot size possible to get you the best income from your annuity, so it makes sense to try and protect your pension funds as you get close to retirement.
However, more and more people don’t want an annuity at retirement. They want to use flexible drawdown whereby they keep the pot and draw on it as and when they need it.
If you go down this route then depending on the age you retire, your pot may need to last you 30+ years. Do you really want it invested in low growth assets? Which is where it would be at the end of the lifestyle fund term.
How rising borrowing costs hurt pension default/lifestyle funds
The ironic thing about default/lifestyle investment funds is that at times they are anything but defensive or safe so it’s misleading to describe as this.
Let’s take Aviva’s lifestyle pension fund range as an example.
I use them because they are a big provider in the UK workplace pension space and I have seen many clients with these types of products.
For pension members who don’t choose an investment strategy when setting up their pensions the default option will effectively be the ‘My FutureFocus Universal Strategy’.
The strategy is made up of three different funds, Long Term Growth, Growth and Consolidation.
As you can see, the closer you get to your selected retirement date, the more you are disinvested from equity funds into bond/fixed interest funds.
So, if you were someone who was about to retire during October 2022, let’s see how the Aviva My FutureFocus Consolidation fund performed.
During the strong rise in government borrowing costs during this period the ‘safe/defensive’ Consolidation fund lost 10% of its value.
This means those pension savers who were invested into it, saw a 10% fall in the value of their pension just at the point they were due to retire and use it.
What’s worst, inflation (the rising cost of living) climbed 11% during the same period.
So, prices got more expensive and people lost a chunk of their pension. Leading to a 20% real loss.
If you were someone who had been planning to buy a pension annuity with your ‘protected’ funds, the impact on what you could have purchased was significant.
To give an example using today’s annuity rates:
A £500,000 pension for a 65-year-old healthy man could provide you with a £125,000 tax free lump sum and a non-increasing annuity of £26,972 per year.
A pension that has lost 10% of its value and therefore now only £450,000 could provide the same person with a £112,500 tax free lump sum and a non-increasing annuity of £24,291 per year.
Now, there is a chance that in the scenario of falling bond values the rates of annuity could be a little higher, but it would all depend on the timing of your annuity purchase.
But in the scenario just described, that’s a permanent £12,500 cash loss and a loss of £2,681 per year for the rest of their life.
All caused because default/lifestyle pension funds are not the things to be invested in when you hear government borrowing costs are rising.
The reason for this is because the value of fixed interest or bond investments including lending to the government in the form of gilts goes in the opposite direction of the interest rate.
Bonds are loans to governments or companies. The amount of the loan and the interest rate will be set at the outset.
These bonds are then traded on public markets.
If more people want to buy bonds, then their value will rise but because the interest rate is fixed it will have the effect of reducing the yield you get.
It works the other way round if there are more sellers than buyers. In this scenario you could pick up a bond at a lower value than what will be repaid meaning your fixed interest rate gives you a higher effective yield.
When it comes to government borrowing much will depend on how markets see the UK’s future prospects.
If they think there is a danger the UK government will struggle to pay its bills in the future, then it will demand a higher interest rate for lending to the government.
This has a knock on effect on all gilts being traded in the market and effectively lowers their price.
Meaning a pension fund heavily invested in gilts and bonds is going to see its value fall.
Avoiding government borrowing costs ruining your pension
To avoid being in the horrific position of seeing your pension fall dramatically just at the point you retire you need to take control over your pension investments.
Firstly, you need to decide what you are planning to do with your pensions at retirement.
Are you going to purchase a lifetime annuity? Or are you going to utilise flexible drawdown and keep the pension invested.
If you are opting for the annuity option, then rather than being heavily invested in bonds that are subject to changes in government borrowing costs you should probably just opt to properly protect your value by either using cash deposit funds or very short-term money market funds.
Yes, inflation may be higher during this time but if it is, cash interest rates should have risen and you will therefore get some return while you wait to purchase your annuity.
You could even lock into purchasing your own short-term gilts that you keep until maturity knowing what your end sum will be.
For example, at the time of writing there is a UK government gilt maturing on 31st January 2028 offering a 0.125% interest rate but crucially can be bought at a discount. Currently trading at £88.92 per unit.
This will mature in 2028 at £100 per unit so you will make a 12.46% return plus a small amount of interest over the three years.
The problem is most workplace pensions will not allow you this level of investment options with the likes of Aviva only usually allowing you to invest in funds.
In this case you will probably need to stick to the deposit or short-term money market options.
Or you could check to see if your pension provider will allow a partial transfer. This could allow you to move your pension funds into a personal pension with more investment opportunities whilst at the same time keeping your workplace pension open and continuing to receive employer contributions.
For those that want to utilise flexible drawdown, you need to consider just how long you will be invested and how much in withdrawals you want to make.
If retiring in your 60s then you will likely have 30 plus years in retirement and therefore it is crucial you are invested more in equities to ensure growth that outpaces inflation over the long term.
Yes there will be periods when equities decline significantly in value but if over the long term declines tend to recover and advance more times than not. A decline is not an issue if you are only making small withdrawals at the time or can afford to hold off selling units until the recovery.
A good global equity fund should achieve this objective. Be wary of workplace pension funds that overweight the UK.
Alternatively, if you are more focused on producing an income from your flexible drawdown pension and don’t want to sell down any capital then you could look at a dividend strategy whereby you choose funds or stocks that pay a good dividend and use this as your income.
Stocks that pay dividends tend to make payments twice a year so if you can find the right companies that pay in different months you could set it up so that you have a dividend pay-out each month.
Or do you need more money in the first year or two of your retirement and less in the later years? Perhaps you need to secure your short-term money in a deposit or short-term money market fund and then place the longer-term money in global equities?
Whatever you do make sure you take an interest in your pension and be clear on what the investment strategy you are using really does.
Don’t be fooled by the workplace pension marketing, nothing is entirely ‘secure’, ‘defensive’ or risk free. Everything has pros and cons and it’s important to know the economic conditions that suit different assets.
If you would like to stress test your legacy planning or even to get a plan in place then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.
