Pension planning: Those close to or at retirement age with a hole in their investments are the worst affected by recent rocky markets
Most pension savers are either protected from the market carnage of recent weeks or will be able to ride out the storm given time.
Those close to or at retirement age with a hole in their investments are the worst affected, though they too may be able to repair the damage by amending their plans or waiting until the current furore subsides.
People in the traditional final salary pension schemes that the Bank of England has intervened to safeguard following the Government’s disastrous mini-Budget – much of what has now been u-turned on – are in the most secure position.
Savers who invest via modern defined contribution pensions will have suffered stock market losses of late, but unless they are near retirement – when some or most of their funds are typically shifted into bonds – they are unlikely to have taken damage in that quarter.
It is too soon to tell whether the sacking of Chancellor Kwasi Kwarteng will calm financial markets, particularly those trading UK government bonds – although the early signs are the u-turn performed on many of the announcements yesterday have helped.
We explain the fallout for investors in bonds in detail here, and look at how it affects people in different types of pension scheme below.
Final salary pensions
Gold-plated and generous final salary pensions provide savers with a guaranteed income until they die, and typically carry on paying a reduced sum to spouses if they survive you.
Much attention has been paid to the Bank of England’s high profile intervention to shore up final salary pension schemes during the current market crisis.
This is because they are heavily invested in bonds, particularly in long duration gilts, but some became forced sellers due to exposure to risky hedging strategies known as ‘liability-driven investments’.
But ordinary members’ pensions are protected, because they individually bear none of the investment risk. Even if the worst happens and their scheme goes bust, their pensions will be rescued by the Pension Protection Fund.
Notwithstanding short-term cash flow issues caused by LDIs, many final salary pension funds will have seen their financial position improve due to recent moves in the bond markets.
Yields, or returns, from bonds have improved as their prices fell in the recent sell-off
‘Although the pension world was rocked by the development that LDI strategies struggled to cope with a sudden rapid fall in gilt prices, there is unlikely to be any direct impact on a pensioner in a defined benefit scheme, either pre or post retirement,’ says Rob Morgan, chief investment analyst at Charles Stanley.
‘The company or institution funding the scheme may need their pension manager to adjust the investment strategy, or they may need to put more money in as a short term measure, but the income promise to the pensioner remains the same.
‘For many schemes, a rise in gilt yields improves the funding position longer term even though it caused a short term bottleneck for those employing LDI.’
Laith Khalaf, head of investment analysis at AJ Bell, says: ‘Defined benefit pension schemes are at the centre of the current crisis, and yet there are several layers of protection which mean individual members of these schemes aren’t in the firing line.
‘These schemes are known as ‘gold-plated’ for a reason, because not only are they generous, but they are guaranteed by the employer, or ex-employer, of the pension member.
‘So even if the pension scheme doesn’t have enough assets to cover its liabilities, it can ask the employer to put more money in.
‘It’s also worth noting that scheme funding has improved markedly over the last year, because while assets have fallen, liabilities have fallen further.
‘As of the last count from the PPF, around four in five schemes were in surplus and the remaining one in five had only a £14.3billion deficit. Conversely a year ago, over 40 per cent of schemes were in deficit to the tune of £116billion collectively.’
Defined contribution pensions
Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.
Unless you work in the public sector, they have now mostly replaced final salary pensions.
People in workplace defined contribution schemes have to shoulder all the investment risk themselves when building their retirement pot.
The vast majority stick with their employer’s ‘default’ fund which is invested in equities – considered higher risk, but higher reward investments over the long term – rather than bonds through most of their working life.
But older workers approaching or on the brink of retirement have been exposed to the recent ructions in government bond markets, and suffered losses as a result.
This is because late in their working life, savers in these schemes are often gradually shifted into bonds, which have historically been regarded as the ‘safer’ option, a process known as ‘lifestyling’, or ‘de-risking’.
The idea is to protect savers against abrupt downturns when they are just about to start tapping their pensions, by buying an annuity that generates a guaranteed income, or more commonly these days via an invest-and-drawdown scheme.
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Workers whose schemes use annuity hedging funds have faced particularly big losses, but have little or no time to rebuild their savings after sustaining losses, says Laith Khalaf of AJ Bell.
But he adds that investors in lifestyling strategies are unlikely to have felt the full force of bond losses, because they are shifted into them gradually and there is usually a cash element too.
And some more modern defined contribution schemes do some de-risking of savers’ default funds ahead of retirement, but might keep a large stake still in stocks, because many people now stay invested in old age.
When it comes to most working age people who have many years to go before retirement, Khalaf says: ‘Defined contribution pensions may hold some bonds, but they will mostly be invested in equities, with the exception of annuity hedging funds.
‘This means in general their exposure to the gilt market is limited. The bond sell-off has also been accompanied by falling equity markets this year and so most people’s pension pot will be smaller than at the beginning of 2022, but after a very long period of growth.
‘This is simply the normal waxing and waning of markets and not something to be too worried about, especially seeing that pension savings are long-term and receive regular monthly contributions, which are now buying in at lower prices.’
Rob Morgan of Charles Stanley says: ‘With both bonds and shares falling in value this year, most people’s pension values have taken a tumble.
‘This isn’t a problem for those with plenty of years left to retirement.
‘Continuing to contribute regularly, adding tax relief and the contributions of your employer in your workplace scheme on top, will mean you are adding to assets at lower levels, and you stand to reap the rewards through compounding your investment returns over time.’
Sarah Coles, senior personal finance analyst, says: ‘If you have a defined contribution pot, and retirement is a long way away, there’s not necessarily any need to make any changes.
‘Default funds (which is where your money ends up if you don’t make a decision where to invest) in the ‘growth phase’ have fallen year to date, but that’s to be expected.
‘You should check the default fund meets your needs, but there’s no need to make any sudden moves.’
What can you do if you are near retirement and sitting on bond losses?
If you are prepared to take a long term view, you can wait out the current market turbulence, suggests Khalaf.
However, you have to be prepared for more volatility, especially if you move out of bonds and into riskier stock markets to make up your losses.
‘There is nothing to stop equity markets falling by 20 per cent in the next year,’ he warns.
Another option is to buy an annuity, as rates have markedly improved lately, says Khalaf.
He says if you do this, you are likely to come out about even, so in that sense annuity hedging funds have done what they are supposed to do with their losses balanced out by more generous annuity rates.
Another option is to ‘mix and match’ by buying an annuity with some of your pot and investing the rest, explains Khalaf. Read more about such strategies here.
Morgan says: ‘One option, if feasible, is working for a bit longer, so that you can keep your contributions and tax relief up and add to your pot while investment prices are low.
‘While it can be tempting to grab what you can from the pension at retirement age, consider whether delaying, and potentially adding to the pot, might lead to a healthier situation further down the line.
‘Investing over the long term – five or more years – tends to be a good way to ride out downturns in the markets, although there can be no guarantees.
‘Although you should avoid making unnecessary changes, it is important to check where you are invested, and you have the right level of risk for your objectives and likely timescales for drawing on the pension.’
‘If you are at retirement and need to take income from your pension while keeping invested, try to do so as sparingly as possible while asset prices are low.’
Morgan also notes that the market volatility has presented a ‘silver lining’ for those wanting to buy an annuity, because the recent fall in bond prices and rise in yields has had a beneficial effect.
‘The income available has hit its highest level in over a decade. Annuities are not right for everyone as you lose access to your money in exchange for a certain income, but with typical rates a third higher than at the start of the year they may be worth considering.’
Coles says: ‘If someone was due to buy an annuity, then whilst they may understandably be unnerved by a big fall in value their income has held up reasonably well. As these ‘old style’ de-risking policies have fallen, so annuity rates have improved.’
She explains that at the start of this year, £100,000 would have bought a 65-year-old a non-inflation linked annual income of £4,950 – an annuity rate of 4.95 per cent. Today, it would buy you an income of around £7,190 – a rate of 7.19 per cent.
Coles goes on: ‘If you were planning to use drawdown to access the money, the good news is that you won’t need it all on day one, so you can leave it invested and grow over the decades of your retirement.
‘However, you will need to revisit your investment strategy to find the right balance of assets for your needs.’