OK, so you have opted for the extra flexibility that a SIPP gives you investing for retirement, but how do you go about using it? Choice is a very useful thing, but it can also be rather daunting, especially where saving for retirement is concerned. You don't want to approach your retirement date and suddenly discover that your pension fund is not worth nearly as much as you anticipated.

So prudent management and regular reviews of the state of your SIPP are called for. One established rule of thumb that financial advisers have traditionally used to encourage investors to think about retirement planning is to suggest that they hold a proportion of their portfolios equal to their age in relatively secure investments, such as fixed-interest securities. So, for example, if you are 25, you might have 25 per cent in bonds and 75 per cent in equities, but at 50, the split would be roughly 50 per cent in each.

The idea is to maintain a sensible balance between higher risk equity investments and lower risk bond holdings that alters over time to reflect the approach of retirement. At 25, when you may still have 40 years in which to invest, a split of 75 per cent in equities and 25 per cent in bonds is reasonable because, over 40 years, shares should produce significantly greater returns than fixed-income investments, and there will be plenty of time for your investments to recover if there is a short-term fall in the stock market.

A wider range of options

This is, of course, a rather crude approach to financial planning, not least because it doesn't take account of the much broader range of asset classes available to investors these days. But the basic principles that you should spread your risk across a wide range of investments and seek to reduce the overall risk level as retirement approaches is still generally applied.

Peter Thomson, chief investment officer at Taylor Young Investment Management, says that 'You have to take notice of the life cycle of the investment. Depending on the age of the investor when they start, you will typically move from “wealth creation"? mode to “wealth preservation"?, then what we term “immunisation? and finally to “income generation"?, for example, if you are in drawdown. The important thing is gauging where people are in that cycle and understanding how the requirements of that cycle change with age.'

He adds, 'I suspect that, generally speaking, people take too much risk in the approach to the immunisation and income generation stages. They probably have most of their funds in equities 18 months to two years before retirement. If their fund then drops 25 per cent over that period, it will have a dramatic impact on the rest of their lives and a lot of people do not realise how much risk they are taking.'

Portfolio management

However, not everyone agrees that age is necessarily the key factor. Stephen Davis, a director of Credo Capital, argues that 'As far as we are concerned, these days there should be very little difference between the asset allocation for your SIPP and your investments outside a SIPP. The advantage of SIPPs is that now you can do a lot within the SIPP framework.'

He adds, 'We see our role as helping clients depending on what their risk profile happens to be, since that is what will determine their asset allocation. Age can come into it to a certain extent at the top end, but only really once you get past 60. In terms of an asset allocation strategy, there is very little difference between a 60 year old and a 45 year old.'

Davis points out that 'You can invest in a very wide range of assets under the current SIPP rules. For us, it is all about choosing the correct risk profile. We categorise risk into three broad bands (see box below) - low, medium or high - although for some clients we would look below low, which would be mostly fixed income or cash. But there would be very few of these, only those who really didn't want to take any capital risk at all.'

He adds, 'If we have quite broad bands, then we will take a view, depending on where the market is, on whether we want to be at the upper or lower end of those bands. This gives us a lot of flexibility, whereas some of the larger institutions will only have leeway of five per cent.'

Davis says, 'Other houses will be taking slightly different views in terms of percentages, but the basic approach will be similar. We review them quarterly, unless something particular happens in the market - for example the Far East crisis of ten years ago - when we will look at them more frequently. But usually quarterly is fine.'

Building blocks

Peter Thomson agrees that a structured approach is important. He says, 'We base our approach to SIPP investment on a series of what we call “building blocks"? and by using different combinations of these over time, it will enable you to develop a strategy over a prolonged period. What we are doing is building a strategy around life cycles and then changing the building blocks on a gradual basis. I liken it to a wall made of Lego, with different coloured building bricks, one colour for growth, another for income and so on. What happens is that you change the colour of the wall as the thing matures.'

He adds, 'In the same way, a SIPP is split up into different portions and you can control what goes on in each one. That gives you flexibility as well as control of everything that goes on in each brick. You can also model these against the Government actuaries' tables to give expected returns and these rates are going to move around quite a bit. But, with interest rates having risen, expectations of drawdown income are going to increase as a result.'

Keep an eye on your fund

Regular reviews of your portfolio are important because investment conditions change over time. Not only do you have to manage the risk profile of your SIPP but you also have to be aware of how different asset classes are performing in relation to each other.

The reason so much long-term financial planning is based on having a core investment in equities is because they continue to deliver strong long-term returns. However, this will not always be the case. The figures in the table to the right - a biannual study that tracks the value of five asset classes over a ten-year period - illustrate that while overseas and UK equities outperformed other asset classes over the past year, in preceding years, other assets, notably residential property, had done better and over the past decade, the best returns had come from UK commercial property.

Clerical Medical Group economist Tim Crawford observes that "Shares have been the best-performing asset class over the past year as strength in the local and global economies has boosted earnings and the UK stock market has outperformed the housing market for the third successive year. Stocks have also outperformed bonds for four successive years with bond performance suffering as rising interest rates have led to a fall in bond prices during the past 12 months."

But he adds, "This was only the second year in the past decade that UK and international shares have been the two top-performing asset classes. Over the past five years, precious metals have been the top of the asset classes tracked, returning 135 per cent or 18.6 per cent per annum (pa). Over the past ten years, commercial property has been the strongest-performing asset class, returning 251 per cent, equivalent to 13.4 per cent pa."

Reducing risk

The breadth of investments permitted within a SIPP certainly enables investors to broaden their asset-allocation strategy, particularly in areas like property, which are generally uncorrelated with the movement of equities and which, therefore, provide genuine diversification. However, partly because of the publicity surrounding the last-minute changes to the SIPP rules at the beginning of 2006, many investors don't realise that they can hold property-based investments within their SIPP, either through a fund or directly.

Stephen Kenny, chief executive of ThePropertyInvestmentMarket.com which allows investors to buy and sell shares in individual residential properties via a SIPP-linked account, observes that 'The perceived inflexibility of all pension schemes is resulting in people opting out of retirement plans. A consumer survey carried out on our behalf reveals that 65 per cent of the respondents would invest more in pensions if they had increasing control over where their money is invested.'

This is, of course, exactly what SIPPs are designed to do. Kenny adds, 'It is concerning that so many people are unaware that they can in fact control their pensions. Many people are misguidedly opting out and missing the opportunity to invest in their preferred investment vehicle while securing their long-term wealth.'

This article is from the September 2007 issue of What Investment.