Warning Perfect Storm for Lifestyle Funds
Published / Last Updated on 29/03/2022
In a recent ‘Traffic Light Alert’, we explained why equities rise when bonds are falling and what had happened to the Nikkei Dow in Japan as stock markets rose.
To follow this up, we now are issuing a warning to consumers that have their pension funds investing in a Lifestyle Fund profile.
What are Bonds?
Bonds are loans to governments and large companies. In simple terms, virtually all pension providers have fixed rate funds, global bond funds, corporate bonds, and UK gilt funds. Some of these will have index linked i.e., inflation protected bonds inside them, most with have fixed rate bonds and gilts. A bond fund or fixed rate fund lends your pension money to e.g., the British Government for a fixed rate of return, these are government bonds known as gilts in UK and when lending to foreign governments they are global bonds.
Inflation and Interest Rate Impact on Bonds and Fixed Rate Bond Funds
For example, you fund buys a fixed rate government bond/gilt at a fixed nominal/face value £100 paying a fixed 3%pa coupon (interest). £3pa income when base/central bank interest rates are 1%pa means you are getting a return premium yield of 2% over bank base rates.
The central bank e.g., Bank of England then increases interest rates to 2% (as they may do later this year) given they are trying to control inflation as is the rest of the World. If you are an investor still seeking a return premium of 2% over bank base rates, you now need a yield of 4%pa (2% bank rate + 2% premium).
The original bond nominal/face value is £100 paying £3pa fixed income but, in needing a 4% yield, you would only pay £75 for that £100 nominal/face value bond still paying £3pa fixed income. £3pa income on a £75 purchase price means a 4%pa yield.
The capital value of the original bond has therefore fallen 25% from £100 to £75. In conclusion, bond and fixed rate funds fall in capital value when interest rates rise and increase in value when interest rates fall. The trend for inflation is up, the trend for interest rates is upwards. Therefore, the trend for bonds is down as investors move away from bond funds and into equity/stock market funds.
What are Lifestyle funds?
These types of pension funds automatically switch you away from higher risk stock market funds to lower risk bond funds and cash funds to protect you from stock market falls and lock in profits as you get closer to your pension’s selected retirement age. The following table illustrates this:
|
Years to Retirement |
% in Stock Market/Equity Funds |
% in Bond Funds |
% in Cash Funds |
|
10 years |
100% |
0% |
0% |
|
9 years |
90% |
10% |
0% |
|
8 years |
80% |
20% |
0% |
|
7 years |
70% |
30% |
0% |
|
6 years |
60% |
35% |
5% |
|
5 years |
50% |
40% |
10% |
|
4 years |
40% |
45% |
15% |
|
3 years |
30% |
50% |
20% |
|
2 years |
20% |
55% |
25% |
|
1 year |
10% |
60% |
30% |
|
Retirement Date |
0% |
65% |
35% |
The above % allocations and switches are automatic.
Perfect Storm for Lifestyle Funds?
Perfect Storm Part 1 - After the recovery from the stock market crash during covid lockdown, stock markets recovered and hit new highs. Late last year, markets fell again with the omicron variant and in 2022, stock markets have fallen again with the invasion of Ukraine. Markets have fallen by around 10%.
If you are 10 years or less away from retirement and you are in a Lifestyle profile, your pension funds will have been switched out of equities during and after stock markets had fallen and into bond/gilt funds. This would have been automatic. In short, you have lost money on your pension fund and then been switched to lower risk bonds meaning you will not benefit from any stock market recovery on the switched part of your pension fund.
Perfect Storm Part 2 – Inflation is high at present and already both the Bank of England and Federal Reserve have increased interest rates. Remember, interest rate rises reduce the capital value of bonds. In the above extreme example, a 1% interest rate rise reduced the value of the bond by 25%. Result: You have been automatically switched out of stock market funds after they have lost say 10% and into Bond/Fixed Rate Funds. Interest rates have increased and are expected to increase meaning your bond and fixed rate funds may fall in value.
This may be the perfect storm for Lifestyle Funds. Automatically switched out of stock markets after market falls and into bond/fixed rate funds that then fall when interest rates are increased.
Whilst lifestyle funds can work in your favour to de-risk your pension and protect from market falls as you move towards retirement; they can also add double misery with the perfect storm of stock market falls then being auto switched for stock markets to bonds followed by bond market falls caused by interest rate rises. Equally then, when bond markets fall, investors switch back to equities driving prices up but you miss out on that recovery as you have already been switched out of equities.
Therefore, we believe consumers should not usually use lifestyle funds but use our ongoing Money MOT service where we de-risk you when the time is right.
