Dealing With Asset Allocation In Retirement

Published in Investing Strategy on 26 October 2009

Your asset allocation may need to change when retirement looms.

So far my mini-series about asset allocation has focused exclusively on wealth accumulation, maximising returns for a given level of risk. Once in retirement the normal 'rules' of asset allocation no longer apply. This because, among other things, the thinking behind modern asset allocation (Modern Portfolio Theory) is based on two assumptions:

1. There are no cash outflows from the portfolio

2. There is a known time horizon.

When in retirement the investment goal is no longer wealth accumulation but wealth 'decumulation' -- the generation of a predictable stream of income for an unknown (but hopefully long!) time horizon. 

Getting down to basics the task is to manage longevity risk (the risk of you lasting longer than your assets). There are two approaches to this; insured annuitisation or self annuitisation. Both have advantages and disadvantages.

Insurance against investment failure

Some time ago I wrote an article for the Fool which looked at how long your retirement portfolio would last under a series of withdrawal assumptions. My conclusion was that withdrawing more than 4% a year, index linked, was quite risky for periods of 30 years.

Furthermore, trying to avoid this by relying on dividends was not entirely safe either because dividends have endured a real decrease in value (i.e. adjusted for inflation) 27 times in the last 64 years (42% of the time). The single worst year was 1998 when real dividends decreased by 16.1%.

Buying an annuity (insured annuitisation) avoids this risk of failure. You hand over your capital, for good, in return for a monthly income for life. Although there are a few variants, the basic choice is between a fixed income or an income linked to the rate of inflation (as measured by the retail price index). 

Current indicative rates for man with £100,000 are given in the table below. Women receive less due to their longer life expectancy.

Annuity typeAge 60Age 65Age 70Age 75
Fixed income£6,238£6,957£7,972£9,447
RPI linked£3,580£4,323£5,352£6,818

Most people hate annuities with a passion. The following reasons are the ones I hear most:

  • they eliminate the possibility of leaving bequests or gifts;
  • people don't trust insurance companies, so they think annuities are unfairly priced; and
  • inflation risk (the retail price index may not correspond your own inflation rate).

In countries where pensioners are not forced to buy annuities, they rarely do so. But this does not mean it's the correct decision.

In fact, most academic research points out that annuities provide the optimal method of reducing risk in retirement, given two caveats. First, that bequests are not important. Second, that the income from the annuity is sufficient to meet the monthly or annual needs of the retiree.

The most compelling piece of research I have found that supports annuity purchase is by professors Babbel and Merrill of the Wharton Financial Institutions Centre.

They crunched all the returns, volatilities, annuity rates and truck loads of other variables to arrive at what the optimum holding of various assets, including annuities, should be for retired investors ranging from minimal risk aversion (0 in the table below) to strongest risk aversion (-5 in the table below). The results are surprising:

Risk aversion0-1-2-3-4-5

Even under conditions of a bequest motive, and 10% price loading for the annuity, substantial annuitisation gave the best result. Go read the research -- it's worth ploughing through all the maths.

Taking on investment and longevity risk yourself

Despite the evidence, many people (myself included) instinctively reject annuities. We like to manage our own money, and reckon we'd like to decide where any excess funds go when we eventually shuffle off this mortal coil.

If you decide self annuitisation is for you then you have no choice but to manage risk yourself. This can be achieved by any one (or combination) of the following strategies:

1. Reduce spending

2. Build in contingency

3. Allocate assets properly

I guess reduced spending is self explanatory. If you've been taking 4% of your portfolio as income and the portfolio drops by 50% then you take a 50% pay cut. Simple. 

Building in contingency means not taking all your investment gains (or dividends in the case of an income investor) but only making partial withdrawals and 'banking' the balance in a risk-free deposit account for the inevitable rainy day. This is the course of action followed by many income-focused investment trusts, that were able to maintain their dividend distributions this year because they had built up substantial reserves (by not paying out all the income received in previous years).

Asset allocation, in this sense, means attempting to match assets to liabilities (in this case your discretionary and essential spending). So, if your essential spending requires £2,000 a year more than provided by your company or state pension then you might invest the appropriate capital sum in low-risk index-linked gilts.

If, in addition you have discretionary spending that you would find difficult to forgo, you could invest an appropriate amount in an income and growth investment trust.

Finally, for that part of your spending which is truly discretionary (chartering a yacht, or spending a month in the Caribbean rather than two weeks) invest an appropriate amount in a growth oriented equity vehicle -- and only splash out if you've made a decent capital gain.

Don't entirely erase annuities from your investment thinking but remember, they provide insurance. And as with any insurance don't buy it if you don't need it and don't overpay for it.

More from Tudor Davies on asset allocation:

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

andyalan10 26 Oct 2009 , 11:04am

Surely the most obvious disadvantage of an annuity is that it is provided by a commercial organisation. They will calculate an annuity level on the basis of their desired profit margin, their costs, and their expectations around life expectancy, inflation and investment returns. "Self annuitisation" removes substantial costs from the equation.

Gibbox 26 Oct 2009 , 11:43am

I agree that an Annuity may not represent the best value for money but it does provide peace of mind. Our financial planning approach is to use an RPI Annuity to provide one income stream that covers the essentials (household expenditure) and use our other income streams (property, ISA's, 25% lump sum) for life's luxuries.

UncleEbenezer 26 Oct 2009 , 2:18pm

I think your figures may be a good demonstration of why life insurers are another bubble waiting to burst. They're committed to long-term outgoings above what can be sustained!

Longer-term, demographics are going to hit all investments from property to shares to gilts to savings, compared to historic figures. Leveraged investments will suffer the most. Anyone who has long-term commitments funded by investment expectations is in a Northern Rock scenario.

To survive, an insurer now would need to hoard now (pay out less than the actuaries say they can), making them uncompetitive at best. Or if the whole industry were to practice prudence, they'd face a huge witch-hunt about profiteering, and big lawsuits for acting as a cartel.

theRealGrinch 26 Oct 2009 , 3:03pm

if you have a pension (SIPP, personal or stakeholder) are you not virtually forced into an annuity by 75 and thus self management is a myth for most working people?

BSDropout 27 Oct 2009 , 1:22pm

Any article talking about asset allocation in retirement for a UK citizen without even mentioning employment or state pensions and the effect this could have on AA is next to worthless. The article is misleading.

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