Is there a missing asset class for retirees?

Conventional wisdom is that bonds and equities are negatively correlated. When equities rise bonds fall and vice versa, but this is a relatively recent phenomenon. 

Analysis of the Bloomberg US Aggregate Bond Index provides 46 years (1976–2022) of data to explore. Comparing this with data from the S&P 500 reveals that equities and bonds moved in different directions about one third of the time and both moved up more than 50% of the time. However, in nearly one quarter out of every 10, both equities and bonds were down. Adjusting for inflation, bonds and stocks were both down approximately one quarter out of six. About once every year and a half.

Source: Bloomberg US Aggregrate Bond index return 1946-2022, (Rick Miller, Sensible Financial Planning).

The relationship between equities and bonds is, in part, a function of inflation. The nominal interest rates that define bond prices reflect inflationary forecasts and real interest rates. When these are both high, bond prices tend to fall. In contrast, equity prices are a function of the strength of the economy. When weaker market growth signals decreasing company profits in the future, the price of equities will usually fall. That means when a combination of high inflation and high real interest rates occur simultaneously with a weak economy, both equities and bonds are likely to fall. 

Bonds are often less volatile

This doesn’t mean investors should abandon bonds during retirement. As well as being negatively correlated much of the time, bonds are characteristically different from equities. They are often less volatile. They can be used within drawdown for income generation or to preserve capital. They may also be used for capital appreciation.  It’s useful to understand how inflation can affect the relationship between the movement of equities and bonds, but bonds will continue to be a key asset in a drawdown portfolio independent of their potential to act as a counter to falls in equities. 

Substituting part of the bond allocation to buy an annuity can provide a better outcome

However, there is a growing body of evidence to suggest that substituting part of the bond allocation within a portfolio to buy an annuity can provide a better outcome for retirees. A study by global actuarial consultants, Milliman, concluded that displacing the bond element of a portfolio with an annuity can lead to higher sustainable withdrawal rates and greater benefits on death.  

This may seem counter intuitive, but it is explainable. Firstly, the higher income from an annuity compared with bonds means less needs to be withdrawn from the drawdown fund to provide a given amount of income. Secondly, the bond-equity strategy is rebalanced each year in the study, but annuities can’t be bought and sold, so the annuity-equity strategy is not rebalanced. Of course, while annuities can’t be sold, further annuities could be bought. Given annuity rates are higher at older ages, this could boost sustainable withdrawal rates further (though this is likely to have a negative impact on death benefits long term). 

This is not the only study to support the view that including a degree of annuitisation within drawdown can lead to better outcomes in many instances. The Institute and Faculty of Actuaries modelled a range of strategies involving drawdown and annuitisation and concluded that by adopting an integrated strategy ‘consumers can potentially generate a larger overall income from their pension pot’.

More recently Standard Life revealed that a combined strategy can produce the highest overall income over a 25-year retirement. The analysis considered someone with a £150,000 pension pot and compared different scenarios. Buying a level annuity with 100% of their pension pot aged 65 would result in a total income of £253,775 by age 90. In contrast, purchasing a level annuity in four phases, starting with £90,000 at age 65, followed by £20,000 every five years, with the balance invested in drawdown (assuming 5% investment return per annum) and taking an income of 3% a year from the drawdown fund, would produce a total income of £259,115. 

A degree of annuitisation within drawdown can also combat sequencing risk. Consider a 65-year-old with a £500,000 fund planning to withdraw 4% or £20,000 income each year. If they buy a single life level annuity with £200,000 this would currently provide over £15,000 each year. That means the client would have to withdraw not much more than 1.5% from the remaining £300,000 drawdown fund, so less has to be disinvested each year or set aside as a cash bucket. This is based on a level annuity, so future inflationary increase would need to be provided by the remaining fund, but this strategy can help overcome sequencing risk in the early years when it is most damaging. 

Annuities should be considered, not necessarily as an alternative to bonds, but as an additional asset class to broaden diversification within a portfolio and potentially deliver a better outcome. 

To find out more, read our latest report Investment risk and retirement.