Shares for the future: the best strategy for my pension savings

When people ask me what I do for a living, I tell them I research shares, write about them, and run a model portfolio for a well-known investment platform.

Often, that is the end of the conversation, which leaves me wondering why people bother asking. On the other hand, if they show an interest, the next question is typically one I cannot answer satisfactorily.

The follow up will be about bitcoin (answer: it’s gambling, I think), soliciting a tip (answer: there is a list of shares at the end of most of my articles. I believe they’re all good long-term investments although some will not be), or financial advice (answer: I am as clueless as they are. More so, probably, as I do not know their situation).

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Last month, during a break in a tennis match, my opponent discovered my vocation, and posed me a question. Sadly, it fell into category three: financial advice.

It was particularly frustrating, because I liked my opponent, and I realised what was to come would not be up there with some of the more stimulating get-to-know-you chats we had already had between games.

Shares ‘till I die

They had some money to invest and wondered, at their age, what proportion they should put in shares and what proportion they should put in bonds. The conventional wisdom, I believe, is that people should invest mostly in shares when they are young, and mostly in bonds when they are old.

Naturally, I explained that I could not give advice. My views are tarnished by my own experience. I only know about shares. Why would I turn everything on its head and start investing in bonds as I get older?

The conventional answer to this question is that shares earn higher returns over the long run, but they are also more risky, meaning their prices are more volatile (they go up and down more).

Youngsters investing for retirement are likely to be better off in shares to capture those high returns. But oldsters, who may need the money to live off, need more stability.

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I have always been a bit suspicious of this advice, principally because we do not know how long we are going to live. If we are going to live to 95, we will still need to be considering the long term when we retire, say in our 60s.

My confidence in this instinctive repudiation of the conventional wisdom got a boost last week when I read about a study in the Financial Times. The title of the article was “How to turn pensions saving on its head”. The title of the study is Beyond the status quo: a critical assessment of life-cycle investment advice.

The study was conducted by three American academics and the data goes back a long way and spans many markets. It measures the performance of various share and bond allocations for a couple who save 10% of their income and then withdraw 4% a year post-retirement at 65.

The mathematical modelling is above my pay grade, hence I am sharing some of the conclusions but not offering an opinion on their validity. The paper is available freely on the internet, though, so if you are interested in the methodology, you can Google it.

The first highlight is no surprise. For an American, a mix of 50% domestic shares and 50% international shares held for a lifetime outperforms a Target Date Fund (TDF) and other strategies that combine stocks and bonds. A TDF gradually reallocates shares into bonds as we get older.

On average, the 50:50 international share strategy generates 32% more wealth in retirement and does better throughout the distribution of wealth outcomes than the TDF. To achieve the same outcome at 65, a couple would have to invest over 14% of their annual income in a TDF on average.

Risk of pain vs probability of ruin

The more surprising outcome is that there is about half the probability of ruin (running out of money before we die) following the 50:50 international share strategy.

The probability of ruin of the 50:50 all share strategy is about 8%. It is nearly 17% for the TDF. Notably, an all-US share strategy generates almost as much wealth as the 50:50 international share strategy, but the probability of ruin is right up with the TDF at just over 17%.

Perhaps strategies that segue into bonds are not as safe as we think. They are less volatile, but we may be more likely to run out of money. Running out of money is a risk I am inclined to worry more about.

However, the authors acknowledge a problem with their favoured strategy. It may be safer long term, but short-term volatility is scary. The 50:50 international share strategy results in an average peak retirement period “drawdown”, or fall from a previous high, of 50% compared to 38% for the TDF strategy.

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If people following all-share strategies are scared out of it when prices crash, they will not reap the benefits. That said, a 38% average drawdown in retirement from the TDF strategy seems pretty scary to me.

The authors say the higher volatility of the 50:50 international share strategy should not deter us. They want financial advice, education and regulation to change, so investors stay the course.

US regulation currently specifies strategies that reduce volatility in the default options in pension plans, for example, not the risk of ruin.

As for education, I imagine it would include the kind of advice dyed-in-the-wool share investors dish out all the time: don’t panic when prices crash. Be patient. Don’t put money at risk that you are likely to need in the next few years...

At this point, you may be wondering what the paper has to say about saving for retirement in the UK and other developed countries.

To take account of the fact that our domestic markets are much smaller than the US market, they propose a smaller home country bias.

Their calculations suggest a 35% weighting in home country shares and a 65% weighting in international shares (of which at least half, I presume, would be US).

It sounds good, but as someone who has devoted himself to learning about UK shares with only about 25% of his retirement pot invested in a fund with a global developed country mandate, I wonder if I could go that far...

Back next week: Shares for the future

As I mentioned, there is usually a list of shares scored for their long-term investment potential at the end of my articles. Unfortunately, this is not one of them!

I am enjoying a week off, so there is no Decision Engine table. Next week it will be back as usual.

Last week’s table is still pretty up to date. I have not re-scored any shares, the only changes in the scores and rankings will be the result of changes in share prices in recent days.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.

See our guide to the Decision Engine and the Share Sleuth Portfolio for more information.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard