Pension-fund deficits continue to hit new highs – not because their investments are underperforming, but because government bond (gilt) yields have fallen to all-time lows. Most pension funds use gilt yields to calculate the value of their liabilities (the benefits they’ve promised to pay in future) and lower yields mean bigger liabilities. The combined deficits of the defined-benefit (DB) pension schemes run by FTSE 350 firms rose by £70bn in August to a record £189bn, according to actuaries at Mercer.
This may not sound relevant to you if you don’t have a DB pension and instead rely on a personal pension or other kind of defined contribution (DC) pension – but it is. While you may not value your own “liability” – the income you need in retirement – in the same way, you are potentially caught in the same trap. The lower yields go, the larger the fund you’ll need to build up to get the retirement income you want by buying an annuity (because annuity rates are essentially set off the back of gilt yields).
If you intend to secure the income by buying bonds instead, you’ll have the same problem. Not only are gilt yields shrinking, but the return on other low-risk bonds is also increasingly paltry: long-dated corporate bonds now yield less than 2%.
That means you may need to consider other ways of generating income. For example, FTSE 100 shares currently offer a yield of around 4% – meaning dividend payments are worth roughly twice what these companies are paying on their bonds. However, equity prices tend to be more volatile than bond prices – not least because companies can cut dividends if they want, but must pay bond interest – so adding shares to your portfolio will increase the risk of capital depreciation.
Asset classes such as infrastructure and specialist debt are now available to more investors than ever before, thanks to collective investment funds – but you also need to make sure that you research the risks of each type of asset. Yet perhaps the most important step for many investors will be taking a “total return” approach to their investments, rather than simply focusing on yields.
Focus on total returns
Investors commonly think of income and capital gains as somehow being separate. Switching to a total return mindset – where you focus on how much the value of your pension fund increases each year, rather than how much is from capital gains and how much from income – might help you to manage your savings more effectively in this environment.
To do this, you need to decide what percentage of your portfolio you can afford to withdraw each year while remaining confident that your savings will last for as long as you need them to. It doesn’t matter whether you’re withdrawing capital or income – or a combination of the two – from your savings, as long as they’re not going to run out before your death. You can then focus your investment strategy on delivering total return, rather than worrying about how to generate income without jeopardising capital.
The conventional wisdom from financial advisers has been that a withdrawal rate of no more than 4% of your portfolio each year gives you a good chance of outliving your savings. This may be too optimistic: we can probably expect lower long-term returns today than was typical in the last few decades of the 20th century. People are also living longer and so will need their savings to last longer.
For this reason, many financial advisers believe an annual withdrawal rate of between 2.5% and 3% is more prudent (the figures will vary from saver to saver, depending on their individual circumstances). But whatever rate you use, this approach gets you away from the income versus capital debate. Realistically, since most people are going to need to draw on capital as well as income, treating them separately makes little sense.