Portfolio Management for Investors In Retirement

Retirees face the most complex stage of their lives from a financial perspective and asset allocation is highly sensitive to personal circumstances

Holly Cook 26 November, 2010 | 1:13PM
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In support of the Institute for Financial Planning's Financial Planning Week, Morningstar.co.uk has spent the last five days offering insights into asset allocation guidelines for individuals in varying stages of life as defined by Financial Planning Week: young, free and single; making commitments; young families; making choices; and in retirement. On this, the final day of Financial Planning Week, Brook Sweeney, Investment Consultant with Morningstar Associates Europe, discusses the important changes investors need to make to the asset allocation of their portfolio to fund their retirement:

For the past four days we have been talking about general asset allocation guidelines as you move through the various life stages as defined by Financial Planning Week’s five ‘life stages’ groupings. In these first four days we talked about the accumulation stage i.e. growing your pension pot. We started with investors in their late teens to mid-20s (the young, free and singles) and moved through to those about to retire. Today, we turn the spotlight on to those who are in retirement.

The first thing to note is that this is a very complex stage of your life from a financial perspective, among other things. At this stage you really should have employed a financial adviser to help you work through the transition from working to retirement. If you have not then it is probably still worth getting some advice.

One particular item of information that not all retirees are aware of is that you can withdraw up to 25% of your pension pot tax-free when you retire. This could be used to finally pay off the mortgage or set up a trust for the grandchildren’s education, or simply to fund your living costs. The UK government has also come to its senses and for many there will no longer be a requirement to annuitise your pension pot, as many previously had to when they turned 75.

There are a plethora challenges for people in this 65+ age bracket, such as inheritance tax, and the size of your pension pot will determine your asset allocation decisions. In Thursday’s article we talked about a number of life choices that should have been made before you moved into retirement. Some of the questions you need to have asked yourself include: what are you expecting from retirement, do you have enough savings, are you going to only semi-retire i.e. work part-time? Something else to consider at this stage is your general health as this will affect your life expectancy. If you are currently 65 years of age then on average you can expect to have 20 years of retirement ahead of you, but you could live longer and 50% of people will (according to the Office of National Statistics).

So now that we have touched lightly on the some of the hard questions you need to consider, let’s turn to some general asset allocation guidelines. The first thing to note is that the longer your life expectancy, the more money you will need to have saved for retirement. Furthermore, the longer your life expectancy, the higher the proportion of assets you should have invested in equities as this asset class, historically, generates higher returns than most other asset classes over the long term. While such a move increases your risk profile, the flipside is that you could run out of money in retirement if you don’t get a decent return on your pension monies. Unfortunately, nothing is that straightforward at this stage of your life though. If you have a huge pool of assets and you are very risk intolerant then you can afford to lower your weighting to equities to reduce risk. If, however, you are at the other end of the spectrum and your pension pot is not very large then it would be unwise to have too high a weighting to equities. This is because if equity markets decline and you have to sell your equities to pay for your living costs then you are crystallising the losses on your equity investments and they will not have the chance to recover, thus you could end up further diminishing your pension pot.

Owing to complexities of the 'in retirement' period we have made some assumptions, which we have listed out below, so that we can provide you with some general asset allocation guidelines. These assumptions are:

1) You are going to fully retire at 65 and are not planning to work part-time;
2) You have limited other assets beside your family home, which you are going to remain living in and you have paid off--or are close to paying off--the mortgage;
3) You are expecting to live to 83 and 85 respectively for males and females. These life expectancy figures are based the Office of National Statistics for those currently aged 65. If you’re lucky enough to be younger than this you are expected to live slightly longer. Please remember this is the average life expectancy, so 50% of you are going to live even longer.

If you meet all of these requirements then on average you are expected to live for another 20 years for females (18 for males). Remember this is only the average! Sorry to hammer it home so hard but it's very important to recognise that the average statistic can fall a long way from the reality. So, based on these assumptions, you now have a 20-30+ year investment timeframe and therefore need to hold a relatively high amount of equity- or share-based investments within your portfolio; unless you have a very large pool of assets to start with you are likely to run out of funds during retirement, especially when you take into account inflation. (You may be surprised to see just how much inflation erodes your purchasing power--take a look at the table below.)

So for the first ten years after retirement, if you are somewhat close to our assumptions then you could consider having approximately 40% of your portfolio in equity investments. This ideally should allow a reasonable amount of your pension pot to grow at a decent rate of return. The other 60% could be in fixed income investments and cash. We would guide you to hold about 10% in cash although this really depends on what your drawdown requirements are and how big your pension pot is.

As you move into the second decade of your retirement you should consider reducing this equity allocation. However, this will depend on your general health and, once again, how large your pension pot is and what your funding requirements are. This is an extremely difficult stage to plan for and we recommend continuing to get financial advice as a few errors at this stage can be very costly in terms of your future standard of living in retirement. While some retirees may be able to go back to work, for the vast majority this will no longer be an option. This is a challenging period for people from a financial perspective so we advise caution and recommend getting professional advice.

Hopefully, we have successfully provided you with a bit of guidance as to your asset allocation, while also highlighting how important it is to seek financial advice, especially as you get closer to retirement, as the tax and regulatory environment is constantly changing and significant sums can be missed out on if appropriate advice is not provided.

Below is a summary of our guideline asset allocations for various life stages as outlined by the Financial Planning Week--read the full articles by clicking on the relevant day:

Monday - 'Young, free and single', in your early 20s you may want a 90% equity/10% fixed income mix
Tuesday - 'Making commitments', in your 30s you could opt for 85% equity/15% fixed income
Wednesday - 'Young families', assuming you’re 35-50 years of age in this bracket you might have at least 75% in equity and up to 25% in a mix of direct property funds or fixed income funds (note that if you already have a mortgage then you do not need additional exposure to property so a higher allocation to fixed income investments would do the trick)
Thursday - 'Making choices', for those of 50-65 years your allocation of asset to equities could reduce to around 60% and the property/fixed income portion rise to 40%
Friday - 'In retirement', after around 65 (or when you choose to retire) you're looking at somewhere closer to 50% in fixed income, 40% in equity and 10% in cash but these broad guidelines are highly sensitive to your own personal circumstances so we recommend seeking professional advice.

Brook Sweeney is an investment consultant with Morningstar Associates Europe.

Morningstar Associates Europe
Morningstar Associates Europe engages with a variety of institutional clients, including investment firms, insurance companies, banks, plan sponsors, plan providers and foundations. The comprehensive array of solutions provided includes portfolio construction and management, strategic asset allocation, manager selection and investment governance/monitoring.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Cook

Holly Cook  is Manager, Morningstar EMEA Websites

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