Traditional methods of asset allocation are being replaced by a better thought out three-stage process that takes into account investment objectives, time horizons and appetite for risk
New demographic evidence shows that we can look forward to 20 years of active and enjoyable living after we have finished creating and maintaining a household. In our eventual decline, we will face four expensive years of dependency and care.
This rosy picture of modern life and expectations raises a financial dilemma for men and women thinking of retiring when their last child has left university. For if they bring their wealth creation days to an end voluntarily, they must also lower their appetite for potentially rewarding but riskier investments at the same time - capital lost cannot be rebuilt.
Yet the 25 years following retirement are too long a time span with too many economic changes and market cycles to retreat to lower risk fixed income investments. In 25 years' time the cost of food and drink, telephones and electricity, house repairs, petrol, travel, clothes, holidays, council tax and medical insurance will have risen significantly and unpredictably. Somehow the retirement portfolios must try to keep up with the way we spend money in our retirement.
Therefore it is essential to develop a realistic expectation of likely investment returns in future and a strategy to provide a cost of living adjusted stream of income with safeguards from the right starting level.
The issues are more acute for pensioners who have already reached the end of their wealth creation days than for their younger colleagues with longer time spans and employment options.
Mistakes made either by being too cautious or too optimistic will cut the standard of living that should have been possible. The older generation, looking back in their retirement, will know that they have lived through a golden age of opportunity.
In the 1980s, the value of shares boomed and in the 1990s property followed suit. In both cases the momentum carried through into the next decade until the exuberance went too far. Shares then endured a savage correction and the property market today is nervously watching prices, mortgages and completions.
The outlook for the current decade reflects a more sombre reality: the need for a return to basics and a down-to-earth realisation that the preservation of wealth is paramount. Warren Buffett once said that there are only two rules in investing: the first is don't lose money, the second is don't forget rule one.
The demise of the company final salary scheme, which had once insulated retiring members from market setbacks, means that the responsibility for the future now rests, more and more, on individual shoulders. And individuals feel differently about their future and are differently placed to cope with their future.
The totally risk averse might choose fixed income securities matching their life expectancy, probably with some shorter term and index-linked holdings. At the other end of the risk spectrum are those who believe that equities, including property, will produce the best results in the long run.
They are happy to live with the strain of market setbacks, as long as their life expectancy is well in the future. They also feel that having a pool of near cash investments will ensure the next five to 10 years' living expenses will be sufficient to prevent being caught out in a bear market, which would mean they would have to sell at a bad moment.
Neither of these approaches pay heed to professional advice on how to minimise risks and maximise rewards at any particular stage in a market cycle. In the past, private investors have instructed their investment managers to do what they think they want doing and the investment managers have responded as best they can - within the highly regulated confines of the institution for which they work. The portfolio has been heavily weighted in favour of equities and the portfolio changes have been aimed at switching overvalued shares into undervalued shares. The tidal flow in ordinary shares has carried the portfolio forward regardless of poor selection.
But now things are different. The outlook for investment is more serious and thoughtful, and institutional ways of reacting to the outlook are being adopted by individuals. Out are traditional methods such as single solutions - growth, balanced or income; tactical asset allocation switches between just two asset classes - equities or fixed interest; and relative performance measurements.
It is now understood that this style showed only a crude understanding of risk. The traditional method is being replaced by three much better thought out stages of advice, all of which need a professional skill. The first stage is defining the investor's investment objectives, time horizons, attitude to risk and any unique characteristics. Stage two is identifying the value of up to half a dozen asset classes in relation to each other and providing an appropriate spread among these different asset classes. The final stage is about managing the different baskets in moving markets, reacting to price changes as they occur.
In responding to the challenge of obtaining an acceptable return, with an acceptable level of risk, over an acceptable span of time, these three stages should move forwards rather like the three hands of a watch.
Stage one is like the hour hand - it involves a periodic review with a close adviser who follows the circumstances and wishes of his client. Stage two is like the minute hand: it requires a faster tempo, managed by an investment consultant whose job it is to value the asset classes against each other. Stage three is like the second hand: the investment manager of the portfolio must respond almost continuously to changes in prices and market sentiment. What I have described is sometimes called a holistic approach to wealth management. It embraces broad financial advice, asset mapping - looking at a client's future balance sheet and liabilities, multiple solutions across the full range of available asset classes, strategic asset allocation for the individual situation, risk and volatility management, equity and bond selection, and real return benchmarks.
A large institutional fund might turn to its actuary to define its liabilities, to an investment consultant to pronounce on the different asset classes, and to an investment manager to get on with the job. Pity the poor private clients who tremble before the thought of three separate fees.
But if they look carefully, they can find all three services under the same roof without paying more than they would for the traditional portfolio management service. Two further important issues are absolute benchmarks and equity risk premiums. Absolute benchmarks, usually expressed as a percentage target over cash deposits or inflation, do not place any value on opportunities lost.
The client's objective is simply either to get a better return than cash on deposit or to protect his or her assets against inflation.
The concept of valuing equities as an asset class is not to denigrate the fact that equities are likely to produce the best results over a lengthy period of time, but to identify when the extra risks involved in ordinary shares seem to outweigh the extra rewards, because shares are over-valued in relation to historic risk-reward ratios.
In the charts below are some figures that could be helpful to anyone in the 55 to 65 age range who is about to, or already has retired, from full-time employment.
George Lynne, new business director, Hichens Investment Management
• If portfolios are to keep up with the way we spend money in retirement a strategy to ensure an appropriate stream of income is essential.
• Traditional ways of determining asset allocation in the 25 years following retirement are being replaced by a better thought out three stage process.
• This involves defining investment objectives, identifying an appropriate spread among up to six asset classes, and managing the different baskets in moving markets.