This article by Chris Gilchrist was published in The IRS Report in August 2011.

Tricky issues in managing your pension

The new rules on pension funds (covered in issues 320 and 321) have changed the game for DIY investors. In particular, abolition of the forced conversion of capital into annuities at age 75 means you can run a conventional portfolio inside your pension fund until you die.

Up till this change, anyone managing their own pension fund always had to keep an eye on the clock. Knowing you had to convert at age 75 meant you had to move towards cash well before this date to avoid the risk of a sudden market fall wiping out capital forever.

No more. If - as Douglas Moffitt is doing with his Rising Income Retirement Portfolio - you are running an equity strategy in your pension fund, it is good for life.

This is good news. But it throws into sharp focus two issues in relation to managing your pension that you need to consider carefully.

The first is the amount you withdraw from your fund as "income", whether this comes from natural income or from capital. A number of US studies have shown that for investors aged 60-65, whose life expectancy now runs to age 90 or above, a withdrawal rate above 4% risks them running out of money.

Clearly designing a strategy that aims to use up the capital in the pension fund is going to be risky, given that you cannot predict how long you will live. That is the great advantage of the annuity - the insurance company does the numbers for you. So most people running their own money will need to build in a pretty fat margin of error, so that some capital remains in their fund on their death. As mentioned in previous articles, given that the final 55% death tax charge more or less balances an initial tax relief rate at 40%, this is not a major issue, especially if you are going to be paying 40% tax on the income withdrawals.

The danger with withdrawals derived partly from capital is the reverse cost averaging effect. If the market falls by 25%, you need to sell 33% more units to achieve the same level of net income. A year or two of this can wipe out so much of your capital that recovery is virtually impossible.

If you have enough capital, then you could design strategies using derivatives to limit the risk, or use hedge or absolute return funds with a large slice of your capital. The simpler solution, which I favour, is setting up a cash fund to hold five years' income when you start withdrawals, and run a conventional portfolio with a high equity content. Personally I would aim to top up the cash account on an ongoing basis from portfolio sales, but if you prefer you can aim to simply slice off, say 5-10% of the portfolio and put it in the cash account every year or two, or when you think the market looks toppy.

Another possibility is to use a "third way" annuity. Offered by the likes of Met Life and Axa, these are investment plans with ratchets that lock in gains and limit the downside risk. These plans are complex - you will need a detailed exposition from a competent adviser.

With equity dividend yields of 3.5%-4% easily attainable in the UK and Europe, this is a good time to be creating a retirement portfolio. Arguably, if your timescale is 30 years and you want a rising income, you should hold almost nothing in bonds - maybe some index-linked ones, or a dabble in high-yield, but not conventional bonds. The less you need to withdraw from capital, the more you can adopt Douglas Moffitt's "buy and forget" equity income strategy, entirely in accord with value investing and Warren Buffett principles and surely the most bankable investment strategy devised.

The second issue is one most people have not even started to think about. It concerns people who are some way off retiring and are still contributing to their funds.

Conventional advice for these people remain to use "lifestyling" to gradually reduce the proportion of capital in risk assets as retirement date approaches. This is correct if you are going to buy an annuity. But it is entirely wrong if you  plan to use drawdown. If you use a lifestyling fund and then enter drawdown you will go from 100% to 0% equities over ten years and then go back to 70% or 80% in equities. This makes no sense whatever.

The implication is that you need to make the decision about whether to use drawdown as much as ten years before your intended retirement date. If you do plan to use drawdown, you will run a portfolio with a much higher equity content right up to retirement. Only if you plan to buy annuities will you start the process of reducing the quity content towards zero at your intended retirement date.

This is a devil-and-deep-blue-sea choice. Aim for drawdown with a high equity portfolio, but then plump for an annuity - and risk large-scale capital wipeout. Or aim for an annuity and use lifestyling, but then decide to go for drawdown - and miss out on huge equity gains you could have secured along the way.

Given the unpredictable changes in personal circumstances that can occur, this is likely to become the most contentious and difficult area of investment planning. Advisers haven't yet realised just how challenging it is, and how hard it will be to recommend appropriate strategies. It's an issue I'll return to in another article.