One writer shows how the cracky stock market has recently validated one of his theories on saving for retirement.
I've written before about why I'm not a fan of `lifestyling.' That's the pension industry's way of dealing with the fact that your pension pot could be damaged by a stock market crash in the final few years before your retirement.
You might think that the recent stock market falls strengthen the case for lifestyling. But I actually think that the recent crash is an excellent example of why you should consider alternatives to lifestyling. And, in particular, my three-step approach.
What is `lifestyling'?
Most people make the decision to have completely withdrawn from investing in the stock market by the time they retire. (This article isn't about discussing the pros and cons of investing beyond retirement. That decision needs to be based on your attitude and personal circumstances.)
`Lifestyling' is the way millions of people remove their retirement savings from shares (or other investments that go up and down in value). This gradually makes your retirement pot safer from short-term falls in the stock market. Typically five years from retirement, your pension provider starts shifting your funds in stages from shares into bonds, cash or some other form of investment with low returns but no possibility of big losses when the stock market falls.
Does it work?
My opinion is that there are worse financial-product features than pension lifestyling. However, for several reasons it is not Foolish...Notice the capital `F', for The Motley Fool!
Firstly, lifestyling is popular because most people have set themselves no retirement-savings target. We're not taking the time to estimate what size pension pot we need. The lifestyle option, therefore, is for many a hedged bet based on ignorance of what pot you require when you stop work. (You can fix that ignorance using my Four-Step Guide To A Comfortable Retirement!)
Secondly, lifestyling contravenes the investing principle that we should invest for the long term. Investing for the long term is by far the strongest defence against short-term losses, because although we can expect shares to perform well over the long-term, we can also expect downward blips along the way.
If you still have some or all your money invested in shares when you have just five or so years left, as is the case when you use lifestyling, you're no longer investing for the long-term and you're at greater risk.
There's an extension to that reasoning: With lifestyling you might continue to place your money at risk of sharp falls when you have no need to do so. This is not necessarily the wrong thing to do. Many of you may be happy to continue to take risks, perhaps because you intend to invest longer, or because your goal is to get as rich as possible. However, others who have reached a pot size that is large enough for them - a pot size they're happy with - should consider the question: `What's the point in taking further risks?'
The alternative way to stop investing before your retirement is to attempt to get out of the stock market altogether many years before you retire.
The financial crisis is a real-life example of the risks of lifestyling
I've been criticised by many experienced investors when I've written about getting out of the stock market early, rather than lifestyling. Their view is that it's too extreme. They argue that people should continue to invest in the stock market if it looks like shares are at bargain prices, or because people should continue to remain invested beyond retirement in any case.
Of course, veteran investors may be willing to try to predict the market (a practice I'm not a fan of) over shorter periods, or to continue investing large portions of their money even after retirement (which I have no problem with).
However, most people, who have less knowledge and experience of investing, would rather have safety and peace of mind. Many of us don't want to be looking at our the pot of money, with which we intend to survive, every day/week/month right up till the day we retire and beyond. Indeed, if you're unsure about the idea of investing longer, if money isn't your strength or special interest, then peace of mind is more important. That's totally ok.
The recent financial crisis has helped show my point. The recession, a credit crunch and other factors have worked together to knock around 30% off the stock market in a very short period of time. People who had an adequate pot invested in shares this time last year and were looking forward to quite a comfortable retirement in five or ten years will now be understandably worried.
(If you're in that situation, there's quite a lot of hope for you, though. My four-step guide shows you that most people massively overestimate how much money they'll need when they retire. There are also one or two tips for you in Save Your Retirement Savings!)
Think of it from their point of view. They've lost around 30%. Even if their pension providers have already `lifestyled' half the savings to safer places than shares, the losses will still on average be a significant 15%.
The worst bit for many of these people is the uncertainty. Now appears to be a great time to invest to get bargains. In five (or more likely ten) years we could easily see a complete recovery and even, perhaps, further gains. But that's not the point. The point is that people in this situation will likely, if they remain invested, face years of worry about whether their funds will recover enough. The funds may even fall further in the interim, giving them more to worry about.
The alternatives are for them to leave the stock market to preserve what's left, to save even more for retirement, and/or to work longer. It's not a pleasant situation.
For those of us with much more time, we would do well to remember this situation, and plan to avoid it in the future.
My alternative: get out of shares when you've reached your target
It's my style to focus on simple strategies that suit inexperienced investors and experienced investors who aren't so actively buying, selling and managing their investments. Here's how you could go about leaving the stock market before you retire, in three easy steps:
1. Calculate what your target pot is. Ensure you add on some extra to take account of inflation. Bear in mind that inflation will likely occur between the time you stop investing and when you retire, plus it will continue most years after you've retired till your death.
2. Aim to reach your target pot early: ten years early if possible, but at the very least five. The later you leave it the more angst you'll have if there's a last-second collapse in share prices. You can use the same four-step guide to estimate how much you need to invest each month to reach your target pot.
3. When you reach the pot size you require, get out quickly. Over a period of, I suggest, six months, move your funds out of shares in roughly equal instalments into the cash or bond funds that are offered within your pension.
I'd like to expand a little on stage three by explaining why you shouldn't remove your funds from shares in one go. When you have reached your pot size and you contact your pension provider to move your pot from shares to something safer, it could still take several weeks for that transaction to be carried out. In that time, the stock market could fall significantly. To protect yourself from fluctuations such as this, it's better to spread the risk over a longer period. In this case, I believe six months should suffice.
> Spread the risk! Save some money for retirement using ISAs. With most ISAs you can access your funds at any time, which is a useful feature in times of financial crisis.
> Read about different ways to Save For Retirement.