How do I invest for the best returns in retirement?

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Many retirees are at risk of bungling their pension finances by falling into one of two easily avoidable traps, according to new research.

A ‘risk-averse retiree’ who believes they are playing it safe by moving pension funds into cash accounts and a ‘reckless retiree’ who chases high returns are both at risk of running out of money in old age, says the study.

Pension firm Royal London shows how easily you can fritter away a £100,000 pension pot in either of these ways, then explains how a ‘rational retiree’ with well-diversified investments has a much better chance of enjoying a comfortable retirement.

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Dilemma: Reckless and risk-averse retirees are both at risk of running out of money in old age

Dilemma: Reckless and risk-averse retirees are both at risk of running out of money in old age

Where is a risk-averse saver going wrong?

People using pension freedoms are switching retirement savings into current accounts and letting them get gobbled up by low interest rates and inflation, previous surveys have shown. 

Pension freedoms launched in spring 2015 have given over-55s far greater control over how they spend, save and invest their retirement pot. But more cautious retirees have simply moved funds into ordinary accounts with no clear purpose.

They must also stump up income tax on anything taken out beyond the 25 per cent tax-free lump sum. Not touching the money in a pension fund keeps it shielded from the taxman.

‘There may be a temptation to lock in past gains by shifting everything into cash when you start to draw an income but playing it too safe can mean your investments stop growing and the pension pot runs dry,’ says the Royal London report.

WHAT IS POUND COST RAVAGING? 

This is also more boringly known as negative pound cost averaging in financial jargon.

It means that when markets fall you suffer the triple whammy of falling capital value of the fund, further depletion due to the income you are taking out, and a drop in future income.

This poses a problem every time markets take a tumble, but is especially dangerous at the start of retirement because investors can rack up big losses and never make them up again if they aren’t careful.

Read more here about how ‘pound cost ravaging’ can irretrievably damage retirement pots in the early days and how to avoid this happening to you. 

‘The average 65 year old can expect to live for more than 10 years, so post-retirement investing is still long-term investing.’

The tables below show what would have happened if you had stuck a £100,000 pension pot in cash ten years ago and taken income of £7,500 a year from age 65 – which was in line with annuity rates at that time, although they are much poorer now.

Royal London calculates there would only be £27,000 left by now and the pot would soon be empty.

‘To make your pension pot last longer you need your investments to grow and that probably means keeping at least part of your money in company shares,’ says the firm.

‘If you’d invested the same £100,000 pension pot in UK company shares ten years ago and taken the same income you’d have benefited from a rising stock market and would still have £48,000 left today.’

This is despite the big drop in value right at the beginning, which can have a particularly negative impact if it happens early in your retirement due to something called pound cost ravaging. See the box above.

If the 30 per cent drop in share prices had come in the final year and not in the first, you would have had £88,000 left over after 10 years not £48,000.

What if you put £100,000 in cash from 2008 to 2017?

Source: Royal London. Fee assumed 1 per cent per annum. Cash return based on JPMorgan cash 1 month UK index, which shows the total return of a rolling investment in a cash instrument

Source: Royal London. Fee assumed 1 per cent per annum. Cash return based on JPMorgan cash 1 month UK index, which shows the total return of a rolling investment in a cash instrument

Source: Royal London. Fee assumed 1 per cent per annum. Cash return based on JPMorgan cash 1 month UK index, which shows the total return of a rolling investment in a cash instrument

What if you invested £100,000 from 2008 to 2017?

Source: Royal London. Fee assumed 1 per cent per annum. UK equity return based on FTSE All Share Index including dividends.

Source: Royal London. Fee assumed 1 per cent per annum. UK equity return based on FTSE All Share Index including dividends.

Source: Royal London. Fee assumed 1 per cent per annum. UK equity return based on FTSE All Share Index including dividends.

What if the 2008 loss had come in 2017 instead?

Source: Royal London. Fee assumed 1 per cent per annum. Return for 2008 is shown as if it happened in 2017 with other annual returns shifted back by a year

Source: Royal London. Fee assumed 1 per cent per annum. Return for 2008 is shown as if it happened in 2017 with other annual returns shifted back by a year

Source: Royal London. Fee assumed 1 per cent per annum. Return for 2008 is shown as if it happened in 2017 with other annual returns shifted back by a year

Where is a risk-taking investor going wrong?

Adventurous investments in overseas property, forests, storage units, airport car park spaces and other offbeat assets can be very high risk – and even at worst scams, as we have previously reported.  

Royal London warns the lure of higher returns can lead some people to take excessive risks in retirement.

It cautions against ‘exotic’ investments linked to aircraft leasing or peer to peer lending that offer yields of up to 8 per cent a year.

‘On the face of it, you could take an £8,000 income on a £100,000 pension pot forever without ever touching your capital. Beware. There is no such thing as a free lunch.

What is the rational approach to investing in retirement? 

‘Pension freedoms open up new possibilities for people in retirement, but create new dangers as well,’ says Trevor Greetham, head of multi asset at Royal London Asset Management.

‘There is the danger of being too cautious and not making your money work hard enough – investing in retirement is still long-term investing. There is also the danger of taking the wrong sort of risk, chasing high returns but putting your capital at risk.

‘We believe the best approach is to spread your money across a range of asset classes and in different markets at home and abroad.

‘This is likely to deliver better returns over your retirement – and a more sustainable income – than being stuck in cash, without exposing you to the capital risks that can come from chasing after more exotic or risky types of investment.’ 

‘Interest rates on safe investments like government bonds or bank accounts are very low today. If someone is offering you a very high rate of interest, the capital may be at greater risk than meets the eye.

‘If at some point interest rates were to rise back to where they used to be a few years ago or if the world economy were to go into one of its periodic recessions, you might find yourself with an unpleasant surprise.’

Royal London also warns retirees against investing their whole pot in mainstream company shares, as they can see significant year to year swings in price. This can be particularly damaging if there is a crash early in your retirement, as explained above. 

Where should a rational retiree invest?

‘There’s a tension here. If you don’t take enough risk, there’s no way your money can grow enough to sustain a reasonable income long into retirement,’ says Royal London.

‘On the other hand, if you exposure yourself to the risk of large losses early in retirement, you could end up in the same place with the money running out unexpectedly early.

Rather than invest in an ultra-low risk or a high-risk way, it says retirees should spread their portfolio across company shares, bonds and property at home and abroad. It suggests the split in the chart below.

A well-diversified portfolio: Source Royal London Asset Management and Moody's Analytics. UK Equities 16.30%. Overseas Equities and and Overseas Emerging Market Equities 16.30%. Property 12.50%. Commodities 5%. Investment grade bonds 11.70%. UK government bonds 11.70%. Index-linked gilts 11.70%. Cash and absolute return 12.50%. Global High Yield Bonds 2.50%.

A well-diversified portfolio: Source Royal London Asset Management and Moody's Analytics. UK Equities 16.30%. Overseas Equities and and Overseas Emerging Market Equities 16.30%. Property 12.50%. Commodities 5%. Investment grade bonds 11.70%. UK government bonds 11.70%. Index-linked gilts 11.70%. Cash and absolute return 12.50%. Global High Yield Bonds 2.50%.

A well-diversified portfolio: Source Royal London Asset Management and Moody’s Analytics. UK Equities 16.30%. Overseas Equities and and Overseas Emerging Market Equities 16.30%. Property 12.50%. Commodities 5%. Investment grade bonds 11.70%. UK government bonds 11.70%. Index-linked gilts 11.70%. Cash and absolute return 12.50%. Global High Yield Bonds 2.50%.

‘This multi-asset approach can be expected to provide better returns over retirement than cautious investing in cash but also helps to smooth the ups and downs of individual investments,’ it says.

‘An active manager can vary the proportions held in each type of investment with the aim of incrementally increasing returns while reducing losses in poor market conditions.’

Royal London also suggests a lower withdrawal rate than in the tables above, where it was assumed someone would take £7,500 a year from a £100,000 pot, in line with where annuity rates used to be 10 years ago.

Instead, it suggests retirees take a more moderate income of £4,500 a year from a £100,000 pot, which would be consistent with the lower annuity rates available today.

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