High inflation and rising interest rates mean the value of ‘lifestyling’ funds has plummeted in recent months and AJ Bell warns it could get worse
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Investors with pension savings in lifestyle funds that automatically shift them into bonds have been warned to reconsider, as faster than expected interest rate rises will hit their value.

The value of so-called lifestyling funds plummeted 13 per cent in the two months to mid-February, as peristent high inflation and rising interest rate expectations bite, leaving hundreds of thousands of workers worse off.

As people approach retirement, lifestyling funds automatically switch the pension savings into assets, another fund, or funds, which generally have a lower risk profile.

The funds tend to invest in long-dated government and corporate bonds, typically judged a safer haven that protects stock market falls and can hedge against annuity rate movements. 

High inflation and rising interest rates mean the value of ‘lifestyling’ funds has plummeted in recent months and AJ Bell warns it could get worse

 High inflation and rising interest rates mean the value of ‘lifestyling’ funds has plummeted in recent months and AJ Bell warns it could get worse

Annuity rates are determined by bond yields, which move in the opposite direction to bond prices.

This means bonds can be a good option for investors looking to buy an annuity with their pension, because any fall in annuity rates could be made up by rises in the value of the lifestyle fund.

If bond yields are rising and the fund is falling in value, annuity rates should rise and thus maintain the level of retirement income. 

Bonds have generally been considered less volatile than equities, but prices are high and yields are very low, and long-dated bonds have sold off heavily as a result of rising inflation and interest rates. 

An estimated 850,000 pension savers are invested in these kinds of funds, according to AJ Bell, but for many savers they are no longer fit for purpose, as they do not go on to buy an annuity with their pension pot.

Since pension freedoms were introduced in 2015, fewer people now buy an annuity instead choosing to keep it invested it for retirement income. This has led to the suggestion that investors should keep more in stock market investments that can produce a better chance of growth or dividend income.

‘The logic behind lifestyling funds is that if they are falling in value, annuity rates will be rising to compensate. 

‘But that’s little comfort if you’re not going to buy an annuity with your pension,’ says Laith Khalaf, head of investment analysis at AJ Bell.

He added: ‘Lifestyling funds are a relic of a bygone era when pension rules basically meant that 90 per cent of people bought an annuity at retirement. 

‘But these strategies are still being used today, when only 10 per cent of people buy an annuity.

‘Pension default strategies that could have been set up decades ago, are only now starting to switch pension investors into these outdated funds.’

Lifestyling funds tend to be used in old workplace pension schemes run by insurers, and individual stakeholder pensions.

While many pension providers have updated their investment strategies to reflect the small number of people buying an annuity, some people may be invested in these annuity hedging funds without knowing it.

As such, Khalaf warns ‘they could be sleepwalking into a bond market sell off’.

Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown adds: ‘These funds are from a time when annuities were the retirement income product of choice – the automatic shift from equities to bonds and cash was designed with annuity purchase as its endpoint. 

‘However, times have changed, and more people are looking to remain invested in the market for longer and may need an alternative solution.’ 

What should those closing in on retirement do?

Savers should look to see if any automatic switching is taking place on their current pension plan and see whether it’s appropriate for them.

The funds will usually be called ‘long gilt’ or ‘long corporate bond’, and will invest in long-dated government or corporate bonds. 

Morrissey says: ‘In recent years providers have sought to address this issue by shifting the lifestyling pattern so it targets income drawdown rather than an annuity for new customers. However, if you have had a pension for a while this is unlikely to have happened, so it is worth checking.’ 

Khalaf sets out what investors approaching retirement should consider when it comes to lifestyling funds.

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‘Those who plan on buying an annuity might consider sticking with their lifestyling strategy, as it should hedge annuity rate movements. 

‘In a rising interest rate environment, they may be better off switching into cash or low risk multi-asset funds, but that doesn’t protect them if interest rates and bond yields fall back again.

‘That looks unlikely, but it is possible, and could be prompted by a resurgence in the pandemic, or a conflict in Ukraine, or an unforeseen catalyst which derails the global economic recovery.

‘Those who plan to invest their pension for income might consider gradually switching their pension pot into income-producing funds, such as Multi-Asset Income funds, and Equity Income funds, which then provide the requisite amount of income needed in retirement.

‘Those who plan to go for growth with their pension and take capital gains might consider holding growth funds in their portfolio and simply carrying on with this investment strategy to, and through, their retirement date. 

‘This is a riskier approach and likely to be favoured by those who have high levels of pension saving, perhaps in the form of a defined benefit scheme, or assets like property, or simply a large defined contribution pension, or some combination of all of these.

‘In the three cases above, investors might also consider gradually building up to a cash pot of 25 per cent of the value of their pension, if they intend to withdraw all of their tax-free lump sum at retirement.

‘Those who plan to take their pension as cash might consider gradually selling out of the market and switching into cash as they approach retirement, so as to avoid any falls in the value of their pot just as they are about to draw on it. 

‘This does open them up to inflation risk, but that really stems from the decision to encash the pension, rather than continue investing it for the long term, which could provide some measure of inflation protection.’

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