The UK’s Financial Conduct Authority has introduced four different ‘investment pathways’ for individuals approaching retirement who have not taken financial advice.
Applicable pension providers must offer these pathways to customers from February 2021. This paper examines potential investment solutions for each of the four pathways, which we summarise below.
Pathway 1. Spend it. ‘I plan to take out all my money within next 5 years’. For those investors planning to take out all their money within the next five years the key considerations are capital preservation and liquidity.
An investment in cash would meet both of these objectives, although we believe an allocation to low-risk asset classes (such as short-dated investment grade credit, asset-backed securities and absolute return bond strategies) can offer more attractive returns without materially impacting downside risk or liquidity.
The key considerations for the ‘spend’ it pathway are capital preservation and liquidity. An investment in cash would meet both objectives. However, given the low returns that cash currently offers, a mix of short-dated liquid assets offering an enhanced return is likely to offer a better expected outcome with limited additional risk. We believe an allocation to short-dated investment grade credit, asset-backed securities and absolute return bond strategies can add customer value within this pathway.
In addition, spikes in short-term inflation, and thus the erosion of the real capital value of the pot should also be considered. However, in practice it may be difficult to hedge against this risk. Short-dated assets with an explicit link to inflation, such as short-dated index-linked bonds or inflation swaps, are not readily available in pooled fund format for individual investors. Investing in floating-rate instruments, such as asset-backed securities, and short dated bonds in general, may provide some level of protection if interest rates are also increased to combat higher levels of inflation.
Pathway 2. Long-term income. ‘I plan to start taking my money as a long-term income within next 5 years’. For those investors who plan to start taking their money as a long-term income within next five years the focus should be on income generation, sustainable capital growth and avoiding major drawdowns.
A well-diversified asset allocation which looks beyond traditional equities and fixed income, with a focus on asset classes which can generate income after retirement, will be key to meeting these objectives.
On this pathway the expectation is that the member will use their investment pot to begin receiving a long-term income within the next five years. To avoid a loss of pricing power in their future income, the pathway should target a return over inflation and will therefore need to take a reasonable degree of risk. However, mitigating the effects of large market drawdowns and preparing the portfolio for drawdown in retirement will also be important. A well-diversified asset allocation with a focus on asset classes which can generate income after retirement will be key to meeting these objectives.
For customers who have chosen to enter drawdown, this is likely to be the pathway that is most popular. We believe the long-term income pathway strategy should be implemented through a diversified blend of: growth assets, such as equities and property, to provide capital growth, core fixed income strategy, such as gilts and investment corporate bonds, designed to offer a high level of secure income and protection in market downturns, alternative fixed income, such as high yield debt and asset-backed securities, to provide additional yield and to add diversification, and liquidity solutions, such as cash, short-dated credit and absolute return bond strategies, which provide flexibility to access cash quickly when required and also further limit market drawdown potential.
Pathway 3. Don’t touch it. ‘I have no plans to touch my money in the next 5 years’ For those investors with no plans to touch their investment pot in the next five years the solution can target a higher return relative to the other pathways.
Investors, however, are still relatively close to retirement, so avoiding major drawdowns is still a consideration. A suitable solution may look similar to the long-term income pathway, but with a larger allocation to growth assets.
On this pathway, the member does not plan to do anything with their investment pot in the next five years. A solution can therefore target a higher level of return and liquidity is potentially less important compared to the other pathways. However, customers are still relatively close to retirement, meaning avoiding large drawdowns will still be an important consideration.
When setting a suitable asset allocation for this pathway, consideration should also be given to what the customer plans to do with the pot after five years. We would expect most customers to target a long-term income from their pot over the longer term. Therefore, a suitable solution for this pathway may look similar to the long-term income pathway but with more of a focus on growth and potentially less-liquid assets.
Pathway 4. ‘I plan to use my money to set up a guaranteed income (annuity) within next 5 years’. For investors planning to set up a guaranteed income (annuity) within the next five years the investment strategy adopted should aim to track annuity rates, as far as practicably possible.
Changes in annuity prices are to some extent driven by changes in long-term interest rates and credit spreads. A strategy invested in medium or long-dated gilts and corporate bonds will therefore be appropriate for this pathway.
In each case, diversified solutions that can look beyond core asset classes are key to building robust portfolios with attractive risk/return profiles.
In contrast to the accumulation phase, income generation is a key consideration in retirement. Therefore, asset classes which offer a strong and sustainable level of income can play an important role in the decumulation phase. This is the case for many alternative fixed income asset classes, but non-fixed income asset classes can also play a role. For example, within an equity allocation, favouring higher income equities.
As this pathway is aimed at annuity purchase, the investment strategy adopted should aim to track annuity rates, as far as practicably possible. However, annuity rates offered by different providers vary and change according to a wide variety of factors, some non-financial e.g. changes in life expectancy and others that are provider specific. It is therefore more challenging to implement an investment strategy that will exactly match changes in annuity rates.
Annuity providers typically back their annuity portfolios by investing in fixed income securities, in particular longer- dated gilts and corporate bonds. As a result, changes to annuity pricing are to a large extent driven by changes in interest rates and credit spreads. A strategy invested in medium or long-dated gilts and corporate bonds can therefore be a viable option for the annuity pathway.
In conclusion, we believe that well-diversified solutions which look beyond the traditional core asset classes of equities, corporate bonds and gilts, are key to providing robust and added-value solutions for people planning their retirement in the near- term. This is particularly the case for those who want a long-term income from their pension pot (the ‘long-term income pathway) and also for those who have no plans for the next five years (the ‘don’t touch it’ pathway).
In addition, low risk fixed income strategies can be blended with cash in the ‘spend it’ pathway to provide an enhanced expected return profile, without materially increasing risk and maintaining liquidity.
More generally, we believe that there will be far more focus on decumulation solutions in the future, as more retirees become reliant on their DC pots as a key source of income in retirement. We believe that the FCA retirement pathways are a step in the right direction, and that this is an area where we expect to see considerable innovation in the upcoming years to meet the wide variety of disparate needs of future retirees.