Investment in equities is undoubtedly an important part of retirement planning. However care must be taken not to rely on them too much says Nick Leitch
According to the June 2007 Lipper Life Office Asset Allocation Analysis report, £121 billion was invested across the 147 funds that report their full holdings in the balanced managed pensions sector. This is a huge amount of money in a hugely popular sector for UK retirement.
However, investors in these funds may not be aware that they are placing a heavy reliance on the performance of a single asset class for their retirement nest egg. While "balanced" and "managed" may sound reassuring, the reality is that funds in this sector often have a very high equity concentration. The average equity holding in managed funds in the Lipper report is 81% with 18% held in bonds and cash. Property accounts for a mere 1%.
Are these clients too equity based? Do they have enough diversification in their portfolios?
It's generally accepted that over the longer term equities have the potential to produce the highest returns compared to bonds and property, but with more ups and downs on the way. However the higher volatility associated with equities needn't unduly bother people in their twenties and thirties with pension savings. They are long term investors, unable to access their savings until fifty-five at the earliest. For them, short-term fluctuations in equities needn't cause concern; they are looking for long-term growth.
Managed funds are a popular choice for inexperienced investors. An advantage of these funds for younger clients is that it gives them substantial exposure to equities during the early years, when the naturally tendency of an inexperienced investor may in fact be the opposite.
However even for younger clients, some traditional managed funds may not be optimal. One of the weaknesses of traditional managed funds is the lack of diversification between asset classes. A reasonable amount of property exposure, particularly 'bricks and mortar' property funds, can provide a good complement to equities. Property funds that invest directly will often have long-term tenants, with long-term rent review periods. These funds benefit from stable and regular rental income flow, which provides a degree of inflation hedging within the fund. There is also the potential for capital appreciation in the property value. A 'bricks and mortar' fund can be expected to behave differently from equities, so helping reduce the risk of over-reliance on a single asset class for long-term growth.
Research carried out by New Star Asset Management at the end of last year suggested that 51% of intermediaries recommended between 11% and 25% commercial property weighting for moderate risk investors. Our research - based on long-term asset class returns and modern modelling techniques - suggests a figure of around 18% for investors with an investment horizon of five years or more. It also suggests that the dual characteristics of capital growth potential and rental income streams, mean that direct property funds can be attractive for investors with different attitudes to risk and with different time horizons.
If a client continues to hold something akin to a typical managed fund asset allocation within the final five to 10 years before retirement, then they should be alert to the risks they are taking.
The chart looks at the 10-year period ending 1 January 2007.
In the last four years taking the equity bet would have delivered good returns - someone with £100 on 1 January 2003 who invested in the FTSE All Share with dividends reinvested, would have accumulated £194 before charges on 1 January 2007. A return matched to the RPI inflation index over the same period would only have delivered £114.
However take a look at the preceding six years. An investor with £100 equities on 1 January 1997 invested in the FTSE All Share would only have accumulated £110 by 1 January 2003. Had the return simply matched the RPI inflation index, the investor would have been £6 better off. Over this period a return equal to the increase in the UK All Stocks Bond Index would have delivered £165 while a return equal to the increase in the IPD UK Property Index would have produced £193.
Our research indicates that 28% equities, 18% property and the balance in bonds is a more appropriate asset allocation for a cautious client who is five years from retirement, and who has the objective of protecting their retirement fund against the effects of inflation.
The research also suggests that for a moderate risk investor who is 10 years from retirement and has a similar objective, 55% equities, 18% property and the balance in bonds would be appropriate.
Of course there is no "one-size fits all" asset allocation.
For example, clients who intend to defer annuity purchase would have a longer investment horizon, and should accept short-term equity volatility more easily.
Every client is different, and the correct asset allocation and equity weighting for them will ultimately vary according to their own risk attitude, the timeframe over which they are investing, their current wealth, and their ability to generate future wealth.
However, for many people invested in balanced managed funds, the suspicion persists that their asset allocation is too equity based.
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