Chapter 7

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Lifecycle Investing

The investment objectives at different phases of life

‘The journey of a thousand miles begins with a single step.’

Lao Tzu

The life journey of each person is unique. However, some phases in the path can be stylised, having similar investment objectives and constraints across individuals. Lifecycle investing can aid envisaging your financial goals during different phases of life and formulating an appropriate strategy.

We break the life cycle into three broad phases:

1. Accumulation.
2. Consolidation.
3. De-accumulation (decumulation).

Accumulation phase

The accumulation phase normally lasts from young adulthood (age of 25) to about 10 years before retirement (45 to 55, depending on your retirement age). In this phase, you are working, earning an income, investing and accumulating wealth. Some of this wealth should be saved for retirement.

The accumulation phase is divided into early accumulation and late accumulation.

Early accumulation

Early accumulation usually starts at young adulthood (25), lasting until early middle age (40). During this phase, the primary financial objectives focus on immediate needs, such as housing, car and starting a family. Emergency cash is important for large expenses, such as a car, education or a deposit on a house.

Net worth is small, but income is growing as you progress from a junior to a more senior job. A primary consideration is debt management, such as taking a mortgage for a house and repaying student loans. Children’s private childcare and public school education could be a major expense, perhaps above mortgage payments.

You may have savings goals, like travelling, nice car, deposit on a house, education and retirement. However, retirement seems so far away, living expenses are high and income is low, so contributions into pension savings are relatively modest. You may be unable, or uninterested, to take advantage of your long-time horizon to start saving early.

Return objective

Your return objective is aggressive growth, beat inflation, target an annual average excess return (return above cash) of 5%, 6% or higher. Return objective should be linked to inflation, such as inflation or cash plus 5% or 6%.¹ An ‘inflation plus’ or ‘cash plus’ objective targets long-term real capital growth.

Alternatively, your return objective can be to maximise potential growth; not targeting a specific return. Adopting a strategy of investing only in equities, for example, does not target an explicit return. It depends on risk tolerance, utilising the long time horizon and low liquidity needs, which are satisfied by income from work. This is the phase to take investment risk.

Risk objective

Given the long time horizon and low liquidity needs from pension savings, risk appetite can be relatively high. An annual excess return of 5% to 6% should be aligned with an annualised volatility of about 10% to 12%, assuming Sharpe ratio of 0.50.²

A 1% risk-free rate is low, matching the current low-yield environment. A ‘normal’ level of risk-free rate is 3% to 4%. When risk-free rate is higher, the required risk level can be lower, as cash deposits generate better returns. However, it may coincide with higher inflation as the BOE tightens monetary policy. So, the total return objective might be higher as well (inflation + 4% equals 6% when inflation is 2%, but 8% when inflation is 4%).³

Investing only in equities requires a risk level of annualised volatility above 15%. This means accepting a possibility of losing over 20% in a single year.

Some investors should consider a conservative, low-risk strategy in their first few years of investing. Sometimes called the foundation phase, it aims to avoid bad investment experiences that might discourage you before you accumulate investment experience, building up your risk tolerance.

Tolerance for liquidity risk is high. You can invest in illiquid assets, reaping the liquidity premium.

Time horizon

Time horizon is typically between 15 and 20 years.

Liquidity

There are no liquidity needs from the pension. Income from work and cash reserves outside the pension should satisfy liquidity needs. The pension is inaccessible until the age of 55 anyway.

ISAs can be accessed. However, you need to return the withdrawal back into the ISAs in the same tax year to reset the tax-free allowance.

Investment strategy

The strategy is aggressive long-term real capital growth. This strategy can include only equities or a mix of mostly equities and other assets, including illiquid ones.

Late accumulation

Late accumulation usually starts at early middle age (40), lasting until about 10 years before retirement (45 to 55 as retirement age is typically between 55 and 65). During this phase, debt management gives way to wealth accumulation. The mortgage is shrinking, although you may still support your children and finance their education and, perhaps, their wedding.

Income from work should be higher than in the early accumulation phase. Net worth is growing. The primary goal is saving for approaching retirement. Time is flying fast. With increased income, you can, and should, significantly contribute into your pension. Consider a strategy of escalation of contributions: making small contributions initially and as salary rises increasing their proportion.

Return objective

Your return objective is growth, beat inflation, target an annual average excess return of 4% to 6% or higher. Return objective may be lower than that of the early accumulation phase, since contributions can grow the pension. But it is not necessarily so. Targeting high returns may still make sense since time horizon is sufficiently long and you may be more experienced and comfortable with investing. Having additional assets outside the pension can justify higher risk tolerance.

Risk objective

Time horizon is shorter than that of the early accumulation phase, but still long. Liquidity needs are low from pension savings. Anyway, the pension is inaccessible. Annualised volatility between 8% and 12% is aligned with the return objectives.⁴

Whilst you may keep a strategy of investing only in equities, consider shifting to a more diversified mix of assets, reducing downside risk. The time horizon may not suffice to recover from a severe market crash as this phase’s end approaches.

Whilst tolerance for liquidity risk is still high, gradually start reducing the exposure to illiquid assets over time.

Time horizon

Time horizon is typically between 5 and 15 years.

Liquidity

There are no liquidity needs from the pension. Income and assets elsewhere should suffice.

ISAs can be accessed (see restrictions above in early accumulation).

Investment strategy

The strategy is long-term real capital growth. Focus on real return (beating inflation). Whilst still growth-oriented, strategy should be less aggressive, emphasising more on mitigating downside risk than in the early accumulation phase.

Consolidation phase

The consolidation phase usually begins 10 years before retirement (45 to 55) and ends at retirement. You have already accumulated assets in the pension. You have finished paying most of your debt, such as mortgage and tuition fees for children. Income from work is still high and expenses are lower, so maximise pension contributions.

This is the last stretch of the marathon. Make the most of annual allowances, aspiring to reach the lifetime allowance. Actually, most people can contribute the most into their pension during this phase.

With 10 years to go, start gradually de-risking the portfolio with a terminal asset allocation in mind. This process is called a glide path.

Terminal asset allocation is the asset mix you aim to hold at retirement. Whilst labelled ‘terminal’, it is not the journey’s end since, after retirement, parts of the portfolio should remain invested. However, it is the end of the accumulation and consolidation phases.

For example, terminal asset mix can include 25% in cash to take as a tax-free lump sum. You may wish to purchase an annuity with, say, another 25% of the assets to provide a steady, secured income stream for the rest of your life. It is a way to mitigate longevity risk and satisfy minimum required needs. You should hold 25% in long-term gilts a number of years before retirement to do so.

Bonds and annuities share similar risks. When interest rates move down, annuity prices move up (and annuity rate down). Buying long-term bonds before retirement hedges changes in annuity price, in particular when bond yields are high.

Part of the portfolio can end up in income-generating assets for post-retirement. They target a yield benchmarked to annuity rate with the flexibility of selling them when requiring lump sums. An annuity lacks such flexibility. The trade-off is that investing for income requires taking investment risk, unlike an annuity.

Life expectancy is usually long after retirement. Hold some growth assets to preserve capital and keep pace with inflation. Retirement does not mean ceasing investing, but that needs, risk tolerance and strategy are likely to change.

The de-risking glide path should be gradual, avoiding selling assets after a drop, close to a trough, or buying assets after a rally, close to a peak. Doing it gradually over time averages buying and selling prices – so-called dollar-cost averaging.

A simple glide path linearly moves from current to terminal asset allocation. This mechanical approach does not need discretion. However, applying high-conviction discretion can help to opportunistically sell and buy assets after big price movements.

Another reason for de-risking the portfolio is sequential risk (timing of drawdowns). Overall average return can be good, but right returns in bad order can be detrimental. Nasty returns in the final ten years before retirement can hurt when portfolio size is big. A dynamic de-risking glide path can mitigate the impact of sequential risk.

Table 7.1 Illustrative linear glide path

Note: T-n is n number of years before retirement (T)

Table 7.1 illustrates a linear 10-year glide path, moving from current 100% equity strategy to a strategy dividing the portfolio into four equal parts:

1. 25% cash for a tax-free lump sum.
2. 25% long-maturity bonds to purchase an annuity to satisfy minimum required income.
3. 25% flexible income-generating asset mix (one quarter equity, one quarter long-maturity bonds, one quarter high yield bonds and one quarter Real Estate Investment Trusts – REITs).
4. 25% growth-oriented asset mix (20% equity, 30% long-maturity bonds, 20% corporate bonds, 10% high yield bonds and 20% short-maturity bonds).

Return objective

The return objective is dynamic, shifting from current return target to annual excess return between 3% and 4%.

During the consolidation phase, the portfolio is transitioned from a growth outcome to income and growth outcomes. Accumulating cash for taking a cash lump sum and bonds for buying an annuity is a liability-hedging outcome.

Risk objective

Shifting from current risk level to an annualised volatility between 6% and 8%.⁵

The tolerance for liquidity risk is diminishing. Gradually sell illiquid assets (except for residential property) over the glide path.

Time horizon

Time horizon starts with 10 years, but shrinks as retirement is approaching. As retirement is getting closer, the time horizon shifts from medium term (about 10 years) to short term (about 1–2 years). Retirement is not the end of the time horizon (it is a new beginning; do not retire from something but retire into something). Parts of the portfolio should remain invested.

Liquidity

There are no liquidity needs from the pension, which is inaccessible until retirement. However, some of the pension gradually moves to liquid assets as per the terminal asset allocation.

Investment strategy

The strategy is dynamic following the glide path.

De-accumulation phase

The de-accumulation phase starts at retirement and continues until the end of life. After saving for many years, you deserve to enjoy the fruits of your labour. During this phase, you live off your savings, spending (de-accumulating) them.

This phase normally lasts from the age of 55 or 65 (your retirement age) to between 70 and 100 or even 120 (with good genes, healthy life and luck). This phase’s length depends on your longevity.

Risk appetite is lower than in previous phases. However, because this phase can be long, the portfolio still needs to track inflation, preserving capital in real terms. Due to longevity risk, you are not sure how long you will need your portfolio to pay income. Some investment risk is needed to keep it going.

Income needs change during retirement. Expenses are typically higher in the first few years as you enjoy the start of retirement, drop as life becomes a bit more sedentary, and increase at the end to accommodate health issues and care. This shape of expenses is called retirement smile.

If you started withdrawing pension benefits, tax-efficient contributions into your pension are limited.⁶ However, you can still tax-efficiently manage existing assets in your pension.

Your ISAs are fully available for accumulating and investing tax-efficiently. Increasingly, people continue working part-time or even full-time after retirement age. Some do so since they are still healthy, wishing to work. Others are forced to do so since they have not saved enough. You may have other income sources beyond your pension, such as rental property. As you may earn more than you spend, tax-efficient savings can still play a role.

Estate planning, such as gifting assets to your spouse or civil partner or family members and friends, can mitigate IHT. Consider using trusts, leaving assets to charities and taking a life insurance with its pay-out going into a trust.

The de-accumulation phase is divided into early de-accumulation and late de-accumulation.

Early de-accumulation phase

The early de-accumulation phase lasts as long as you are still relatively healthy and active. Some people continue working, either full-time or part-time, earning income after retirement age. This means that whilst your quality of life greatly depends on savings and assets that you have accumulated, you still have some leeway to do something if they are not sufficient.

Return objective

The return objective is income and capital preservation, mostly in line with inflation. Target return depends on the amount of accumulated savings and income level needed from the portfolio to maintain the desired standard of living.

For example, you need £40,000 annual income and your pension’s size is £1 million. The return objective is 4% income. The portfolio needs to keep pace with inflation at 2% per year, meaning a 6% total return objective. This return objective might be aspirational, requiring an adventurous 10% volatility.⁷

With £1 million you will probably need to be satisfied with £30,000 income per year and perhaps a growth rate of only 1%, accepting erosion of the portfolio’s purchasing power over time due to inflation. The new total return is 4% and a conservative risk level of 6%.⁸

Risk objective

To mitigate the risk of depleting the portfolio, it needs an annual volatility of 6% to 10%. Such volatility allows generating returns to cover income needs and keeping pace with inflation.

Sell any remaining illiquid assets, except for residential property, unless there are good reasons to retain them.

Time horizon

Time horizon could be over 30 years. By the time we retire advances in medicine can mean people will live longer than today. This is good news, but it is also bad news. You will need to be prepared to preserve some of your portfolio’s capital for many more years. Keep investing after retirement, unless you take an annuity that will satisfy your financial needs.

Liquidity

You are drawing retirement benefits from the portfolio. It must hold cash, liquid investments you can sell to raise cash (drawing capital), income-generating investments (taking the natural yield) or an annuity.

Keep a cash reserve for emergencies, such as healthcare.

Investment strategy

The strategy is income and capital preservation.

Late de-accumulation phase

The late de-accumulation phase covers your last years, starting at the age of 80, 90 or 100. It depends on your health, lifestyle and activity level. At this phase, the main concerns are covering ongoing living expenses, care and healthcare.

Now, it is too late to find new sources of financial support (with rare exceptions of a financial windfall, such as inheritance – although you probably outlived most candidates for inheritance, lottery win or a property or business sale). You cannot work any more. You might be unable to make financial decisions due to health problems, such as dementia. The decisions you have taken during your life determine your financial security. You must be in a position of having sufficient assets remaining to provide for your financial needs at this life’s late phase. And your finances should be simple, low maintenance.⁹

Longevity risk is acute. If you live longer than expected and run out of money, it is a dramatic problem.

The late de-accumulation phase finishes with the end of life. However, you may wish to leave assets for your heirs or a legacy by contributing to charities. Even at this final phase, you may still aim to preserve capital.

Return objective

The return objective is annual income of 2% to 3% and perhaps 2% capital growth.

Risk objective

The risk objective is to minimise downside risk, volatility of 6% to 8%.¹⁰

Time horizon

The time horizon could be over 10 years. You cannot know for sure.

Liquidity

You are drawing retirement benefits from the portfolio. Keep a cash reserve for emergencies, such as healthcare.

Consider gifting parts of your assets to mitigate IHT.

Investment strategy

The strategy is income and conservative capital preservation.

Dynamic investment strategy

Lifecycle investing demonstrates how investment objectives and constraints change during life. One key for successful investing is being dynamic, adapting to changing circumstances. Your strategy should be dynamic and adapt to your changing financial needs.

Your investment objectives

When planning for your future, take a conservative approach. After retiring, your savings need to generate an annual income. The required income level depends on whether you and your partner have other financial sources, such as State Pension, DB income, part-time job or rental properties, and your desired standard of living. Your portfolio size, its annual growth rate and time horizon limit the available income level.

Figure 7.1 shows how quickly your pension can be exhausted. It assumes a £100,000 initial portfolio, initial drawdowns growing at a 2% annual rate to keep up with inflation and 5% nominal annual portfolio growth rate. The initial drawing rate of 8% exhausts your portfolio in 15 years, but an initial drawing rate of 5% keeps it going for 30 years.

As a rule of thumb, most people need about half of their pre-retirement income to be satisfied at retirement.¹¹ When retired, some expenses fall. For example, mortgage and other debt should be paid off and you stop paying for children’s education. Some other expenses may increase, such as heating, leisure costs and healthcare costs. Overall, however, it should be possible to maintain your pre-retirement standard of living with half the income you had before retiring.

Annuity rate can be used as a conservative estimate of expected annual yield from your portfolio. If annuity rate is 5%, you will generate an annual income of £25,000 on every £500,000 saved.¹²

Is £25,000 enough for you to live the way you desire post retirement? If yes, then your target saving amount at retirement is £500,000. If you need more, say, £40,000, you need to reach £1 million. Is that realistically achievable?

When you know the amount you want to save, work backwards, deriving your return and risk objectives. Given time and contributions, work out the target average annual return and risk level.

With increasing life expectancy, you will need to preserve your portfolio’s capital for around 30 years after retirement. Your portfolio should at least keep pace with inflation. With 2% annual average inflation, post retirement your portfolio’s minimum total return should be around 4% or 5%.

Now you are equipped with the tools to formulate your return and risk objectives, considering your investment constraints, for different phases of your life cycle. This is the first step in designing your investment strategy, fitting each phase. The next step is, with your strategy in mind, choosing and blending appropriate investments.

Summary

• Typical life phases are: (1) accumulation; (2) consolidation; and (3) de-accumulation. Each phase has different return and risk objectives, constraints and an appropriate strategy.
• During early accumulation, your time horizon is long and risk tolerance can be high. Seek aggressive growth and perhaps invest your entire portfolio in equities. Your target excess return should be 5%, 6% or higher, with a volatility level of 10%, 12% or higher. You can invest in illiquid assets.
• During late accumulation, your time horizon is shorter, but your income from work should be higher than early accumulation. Focus on growth, but with lower downside risk than previously. Your target excess return should be 4% to 6%, with a volatility level of 8% to 12%.
• During consolidation, start a 10-year glide path de-risking from current strategy to your target portfolio at retirement – the terminal asset allocation. Your target portfolio can include cash for a tax-free lump sum, long-term bonds to hedge the price of an annuity, income-generating assets and growth assets. Transition from a growth outcome to income and growth. Gradually reduce illiquid assets, except for residential property.
• During early de-accumulation, your portfolio should generate income. However, capital preservation and keeping pace with inflation are important. You are likely to need to continue investing after retirement. Your target return should be 4%, with a 6% volatility level.
• During late de-accumulating, your portfolio should generate income, as well as preserve capital. Longevity risk means you may live a long time and need your assets to safeguard your financial security.

Notes

¹Assuming an annual inflation rate of 2%, inflation + 5% translates into 7%.

²Sharpe ratio = return − risk free) ÷ standard deviation = excess return ÷ standard deviation; 10% = 5% ÷ 0.5; 12% = 6% ÷ 0.5.

³The FCA sets assumptions for pension projections. The assumed annual inflation rate is 2.5%. The growth rates before inflation are 2% (lower), 5% (medium) and 8% (higher). The growth rates after inflation are –0.5%, 2.5% and 5.5%.

⁴8% = 4% ÷ 0.50; 12% = 6% ÷ 0.50; assuming Sharpe ratio 0.50.

⁵6% = 3% ÷ 0.50; 8% = 4% ÷ 0.50; assuming Sharpe ratio 0.50.

⁶Once you take advantage of flexible drawdowns, your annual allowance drops from £40,000 to £10,000. This is unless you are already in an existing capped drawdown scheme.

⁷10% = (6% − 1%) ÷ 0.50, assuming risk-free rate 1% and Sharpe ratio 0.50.

⁸6% = (4% − 1%) ÷ 0.50, assuming risk-free rate 1% and Sharpe ratio 0.50.

⁹Age UK is a charity dedicated to helping people over the age of 60. Its website at www.ageuk.org.uk has plenty of information not only about financial matters, but also about other topics, such as health, care, work, learning, benefits for pensioners (such as housing benefits, cold weather payments) and lifestyle. The website includes a free benefits calculator.

¹⁰6% = (2% + 2% − 1%) ÷ 0.50; 8% = (3% + 2% − 1%) ÷ 0.50; assuming risk-free rate 1% and Sharpe ratio 0.50.

¹¹Age UK at www.ageuk.org.uk offers a free pension calculator helping to plan for retirement, including expected expenses and benefits.

¹²£25,000 = 5% × £500,000.