Is de-risking a good idea?

Following significant pension reforms introduced in the 2014 Budget, UK pensioners can now withdraw large cash sums at times of their choosing.

The initial fears that self-managing income drawdown investors might use the proceeds to purchase sports cars or other extravagances have not been borne out.

However these individuals still face several difficult decisions for managing their money through retirement.

One key question is whether they should de-risk or rerisk with age. More precisely, should they decrease or increase (or keep the same) the percentage of their portfolio in growth assets such as equities?

Conventional wisdom says that they should de-risk. For instance, one rule of thumb suggests that investors should hold a percentage in equity equal to 100 minus their age, meaning a typical 65 year-old should hold 35% in growth assets whereas an 85 year-old would hold 15% in growth assets. The rest would consist of relatively safe assets such as cash and high-quality bonds.

The simplicity of this old guideline is appealing, but does it really stack up?

A shifting balance of risks: investment risk and longevity risk

A good place to start is the risks that retirees face. Retirees are exposed to two key types of risk: investment risk (the risk that returns are lower than expected) and
longevity risk (the risk that they outlive their available funds). Both contribute to the overall risk of running out of money.

Our research shows that investment risk matters less as retirees age whereas longevity risk (which drawdown investors cannot ‘pool’) matters more with age. Eventually longevity risk, rather than investment risk, dominates the overall risk of running out of money.

The percentage impacts on ‘prudent’ withdrawal rates an investor might make as a result of both investment and longevity risk1.

This prudence acts as `self-insurance’ against that risk, allowing a buffer to build up in case assets perform worse than expected or the pensioner lives for longer than expected.