Pensions threatened by bond 'bubble'

Are you hoping that annuity rates will have improved by the time you retire? You may find that, even if they do, it won't increase your retirement income.

There are serious concerns that thousands of people approaching retirement could see the value of their pension fund plunge when the so-called "bond bubble" bursts.

Demand for bonds and gilts has been high in recent years, as they are seen as lower-risk assets than shares. This has helped push prices up, and yields down. This partly explains why annuity rates have tumbled, as they depend on gilt yields.

Many people approaching retirement may be hoping for a reversal in fortunes, as rising gilt yields should signal higher annuity rates. However, many may not realise just how exposed their pension funds are to these assets, which they may have bought at inflated prices. Any gain in annuity rates is likely to be more than offset by a corresponding fall in bond and gilt prices.

Many pension savers may have chosen to invest in bond funds. But millions more will find their pension funds automatically switched away from shares and into bonds as they get older. The practice is known as "lifestyling" and is designed to insulate portfolios from dramatic stock market swings. This is because bond prices have historically been less volatile than shares. Company pension schemes tend to adopt the practice, as do many personal pension plans.

Lifestyling is normally a progressive process, with the percentage of your fund in bonds gradually rising as you approach retirement. It can start five, 10 or 15 years before you stop working. For example, in the first year you may see 20pc of your assets switched to bonds, whereas in your final year before retirement you could have 80pc in bonds and gilts, with the remainder in cash. Correspondingly, the proportion in shares would fall from 100pc to 80pc in the first year and then gradually to zero.

The process takes place automatically, although your pension fund manager should write to advise you that it is about to start.

It sounds like a sensible idea, and has sheltered thousands of people from the full effects of stock market crashes. But lifestyling has never been tested in a bond bear market; pension funds started using the technique in the mid-Nineties, and since then there has not been a serious correction in the bond market.

But the fear at the moment is that as bond prices have been driven to excessive levels by investors seeking safe havens, once economic conditions begin to return to normality the fall in bond prices could be severe and sustained. The effect on lifestyled pension funds could be dramatic.

"When bond yields do eventually rise, lifestyle funds stand to lose investors a lot of money," said Laith Khalaf of Hargreaves Lansdown. "We estimate that if yields on long-dated gilts rise back to levels seen before the Bank of England embarked on quantitative easing, a typical lifestyle fund could lose 30pc of its value."

Charles Morris of HSBC added: "The theory of moving from shares to bonds as you near retirement is fine, but you have to consider the price at which you buy. Bonds are horrendously expensive by any measure at the moment. There's no value in them unless you believe that perpetual deflation is on the way."

Even bond fund managers are cautious. Chris Bowie, manager of the Ignis Corporate Bond fund, said recently: "Bonds should definitely not be a buy for investors right now – I would say get ready to sell." M&G has also moved to discourage new investment in its bond funds.

Bond bulls, by contrast, are hard to find.

If you are worried that your pension fund could suffer in the event of a bond rout, it's time to take stock. First, find out where you stand. The managers or trustees of your pension scheme will tell you if it uses lifestyling, when the switch to bonds starts and what the current make-up of your pension is. Don't forget that you may have other funds from previous employers.

Next, ask yourself whether or not you intend to use your pension pot to buy an annuity. If so, the danger from bond price falls is at least partially offset by the fact that annuity rates should rise. But Ros Altmann, the director-general of Saga, warned: "The big risk is that annuity providers won't push rates up in step with gilt yields. There is no transparency in the way they set rates, and they could use the imminent ban on different rates for men and women, or later tightening of solvency rules, as an excuse for caution."

She estimated that in the event of gilt yields rising to 4.5pc from their current level of about 2.3pc, the value of a lifestyled £100,000 pension pot (£75,000 in bonds, £25,000 in cash) would fall by about 34pc to £66,250. Even if annuity companies raised their rates by two percentage points as a result of better gilt yields, this fund would buy an income of about £4,950, compared with £5,500 from a £100,000 pot at today's annuity rates. In other words, a fall in gilt prices would result in a 10pc drop in annual retirement incomes, despite the corresponding improvement in annuity rates.

If you don't plan to buy an annuity, lifestyling is probably not for you. Alan Morahan of Punter Southall, the pensions consultancy, said: "Most drawdown investors buy shares with their pension savings. If their pension fund was previously lifestyled, they will in effect have sold shares to buy bonds, then gone back into shares, which is pretty nonsensical."

If you feel that you are overexposed to bonds, or plan to use income drawdown, many schemes will allow you to reduce your exposure or switch to another fund within the scheme. Alternatively, you could start managing the money yourself by transferring your pot to a Sipp (self-invested personal pension). But check for any exit penalties or valuable guarantees and be aware that if you leave a scheme provided by your current employer you will probably lose the contributions it makes.

If you do switch funds or start a Sipp, where should you invest your money?

Experts suggested diversified funds that own a mix of shares, bonds, cash, property, commodities and alternative assets, for example. These portfolios should be more resilient in the event of a bond crash than a simple lifestyled fund. Some company pension schemes offer access to popular funds such as Standard Life's Global Absolute Return Strategies (Gars) and Newton Real Return, both tipped by Mr Khalaf.

If you are in a lifestyled fund and are happy to stick with it, make sure that the scheme knows when you plan to retire – if you intend to work five years beyond your normal retirement date, for example, the switch to bonds will start too soon.

"The problem with lifestyling is that it's a completely mechanical process and you risk buying bonds or selling shares at the wrong time," said Mr Morahan. Ms Altmann added: "It could turn out that you sold shares cheaply in order to buy expensive bonds."