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Regarding pensions, what is the best age appropriate asset allocation with regards to stocks/bond funds?

23 November 2021

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Question by Paul

Hi, I'm in my late 50s and hoping to retire in approx 5 years. Regarding pensions, what is the best age appropriate asset allocation with regards to stocks/bond funds? Also what happens to the stock/bond markets if interest rates rise? Are corporate bonds safer? Basically where is the best place for future growth and protection of existing capital?

Answered by Scott Gallacher

There isn't really one best place for future growth and protection of capital. However, there will be the right place for you.

Given you are retiring in approximately 5 years' time it is important to consider how you might take your pension benefits.

Historically people took the maximum tax-free cash lump sum (normally 25% of the fund) and used the balance of the fund to purchase an annuity (guaranteed income for life).

This annuity approach is less popular today due to lower annuity rates*. However, this approach still has a place for more cautious people or those that need the security of a guaranteed income.

If you are likely to be purchasing an annuity when you retire then it would be prudent to consider lower-risk allocations in the meantime. You don't really want your pension fund dropping significantly before you retire as the annuity you can purchase will be lower.

*Note annuity rates have risen slightly recently but are still low by historical standards.

Traditionally this lower-risk approach, as you near retirement, has been achieved by reducing your allocation to equities and increasing your exposure to fixed-interest or cash.

Fixed-interest holdings can still fall in value, especially if interest rates rise. However, as their value is normally linked to interest rates, there is an element of offsetting with annuity rates.

For example, if interest rates rise then the value of fixed-interest holdings would be expected to fall. However, in this situation annuity rates would be expected to rise (due to higher interest rates). This increase in annuity rates would be hoped to offset some of the loss due to falling fixed-interest values. Hence the annuity income you could purchase might not be too affected.

More recently, instead of purchasing an annuity, many people have instead been using Drawdown.

Drawdown means that your pension fund remains invested and you take regular or ad-hoc withdrawals (drawdown) from your pension pot. You might still have taken the maximum tax-free cash lump on retirement or you might use this as part of the regular and ad-hoc withdrawals.

Drawdown may give much greater flexibility, better death benefits and possibly higher income (certainly in the early year). However, Drawdown it is a much riskier option.

Draw too much, pay too much in charges, suffer poor or negative performance, or simply live too long, and you risk drawing down the entire fund. And, when the entire fund is spent, you would have no continued income.

If you are likely to use Drawdown in retirement, then you will need a certain level of investment return to make this viable. Consequently, as the pension pot will remain invested after retirement, there is less need to reduce risk significantly as you near retirement.

Though, of course, you should ensure that any pension or investment is at the appropriate risk level for not only your needs but also your attitude towards investment risk. Some people should not take too much risk because either they cannot afford the potential losses, or simply psychologically they couldn't cope with the ups and downs of the markets.

Given you are retiring in approximately 5 years’ time there is arguably a third approach which we have used to good effect with some more cautious clients. That is the use of With-Profit pension funds to deliver medium risk-return but with an element of downside protection. With-Profits have a very poor reputation but if used in a specific way they can be a great alternative for those nearing retirement. Specialist advice is needed to ensure that With-Profits are used correctly as there is still the risk of capital loss.

I have covered what might happen to bond markets if interest rates rise, i.e. the bond markets might fall. Corporate Bonds are normally higher risk than Gilts and government debt.

Stock markets are a little harder to judge as modest rate rises should be fine for stock markets but larger rises could cause stock markets to fall. For example, rising interest rates might be a sign of current problems (high inflation), could reduce consumer demand (higher mortgage costs eating into disposal income) and could reduce company profit margins (cost of servicing company debt).

Remember investments and pension funds can fall as well as rise. My answer is intended as guidance only. It is not intended as individual advice.

If in doubt as to the best course of action for you, you should seek professional advice from a qualified independent financial adviser.

Answered by

Scott Gallacher

Chartered Financial Planner

The financial services industry often confuses people with jargon. However, I pride myself on my knack for making the complicated understandable.