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850,000 pension savers could be sleepwalking into a bond market nightmare

Laith Khalaf, Head of Investment Analysis, AJ Bell
  • An estimated 850,000 pension savers are invested in ‘lifestyling’ funds, which have fallen in value by 13% in the last two months
  • These funds invest in long dated bonds, which have sold off heavily as a result of high inflation and interest rate rises
  • People are shifted into these funds as they approach retirement in order to hedge against annuity rate movements
  • But since the pension freedoms were introduced, only 10% of pension investors now buy an annuity
  • Pension savers in their 50s or 60s are automatically defaulted into these funds as they approach retirement, but for many they are no longer fit for purpose
  • The FCA’s default fund plans could be storing up problems for the future

 Laith Khalaf, head of investment analysis at AJ Bell, comments:

“Lifestyling funds are a relic of a bygone era when pension rules basically meant that 90% of people bought an annuity at retirement. But these strategies are still being used today, when only 10% of people buy an annuity, thanks to the pension freedoms which were introduced in 2015. Pension default strategies that could have been set up decades ago, are only now starting to switch pension investors into these outdated funds.

“Many investors probably won’t be aware this is going on, but they could be sleepwalking into a bond market nightmare. That’s because high inflation and rising interest rates have led to a 13% fall in the value of these funds in the last two months. If these trends continue, things could get even worse from here. 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.

“These funds will often be used in old workplace pension schemes run by insurers, and individual Stakeholder pensions. Many of these pension providers have now updated their current investment strategies to reflect the fact that few people are buying an annuity in today’s retirement market. But older pension plans are still ploughing on ahead with their default investment strategy of automatically shifting investors out of equities, and into these lifestyling funds which hedge annuity rate movements. For most pension investors, who aren’t going to buy an annuity, these funds are now totally unfit for purpose.

“Investors who are approaching retirement should definitely take a look under the bonnet of their pension plans to see what’s going on, and if any automatic switching is taking place, they can then make an informed judgement on whether it’s appropriate for them, based on what they’re going to do with their pension. If you think you might be invested in a lifestyling fund, check your latest valuation or speak to your pension provider. The funds in question will normally be called “long gilt” or “long corporate bond”, and will invest in long-dated government or corporate bonds. If you are going to buy an annuity with your pension, you might consider sticking with a lifestyling strategy. But if you aren’t, then you should give careful consideration to picking another type of fund to see you through to retirement, and beyond.”

What is a ‘lifestyling’ or ‘annuity-hedging’ fund

Lifestyling funds, or annuity-hedging funds, invest in long-dated government and corporate bonds, with the objective of hedging annuity rate movements. They work in this way because annuity rates are determined by bond yields, which move in the opposite direction to bond prices. So if you’re invested in a long dated bond fund, this should move in the opposite direction to annuity rates. Switching into one of these funds as you approach retirement can therefore be a good idea if you’re going to buy an annuity with your pension, because any falls in annuity rates are made up for by rises in the value of your lifestyle fund, and so your ultimate retirement income remains around the same. Conversely, if bond yields are on the up, your lifestyling fund might be falling in value, but annuity rates should be rising, again broadly maintaining your level of retirement income.

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