I received an email from a client looking for some help last week. His employer wrote to him advising they had changed the investment policy for their pension fund, outlining the reasons and relaying their employees’ options.
They were giving them a choice of nine different funds to choose from. Three of them fell into a low-risk category, three in a medium-risk one and three were deemed high-risk. They wanted employees to choose which funds they wanted to invest in and how much of their monthly contribution was to go into each.
Even though they gave them a summary of each fund, he had absolutely no idea what he should be investing in, hence his email.
He didn’t even know what funds he had previously been investing in, but he thinks it was all high risk, because when he joined the scheme he was in his twenties and was told that a high-risk fund was the one he should opt for; not bad advice, by the way.
Aside from those nine options, there was one other option open to him, which was not selecting any of the funds offered or apportioning any percentage towards each, instead he could choose a default option.
If you don’t have the confidence or knowledge to make an active choice yourself from all the funds available, the pension administrator, knowing this, will offer a default fund which is designed to suit as broad a range of employees as possible. The majority of people I come across choose this route because it appears to be the safer option.
The default fund is sometimes referred to as a lifestyle fund which means that as you get closer to retirement age, the fund automatically shifts the balance of your investments from riskier assets e.g. equities, towards less risky assets e.g. cash/bonds.
The advantage of this is that it happens without the employee having to give an instruction to the fund managers and more importantly it prevents your fund from being wiped out as you near retirement.
My advice to anyone, whether their employer is changing an investment strategy or not, or whether they are starting their own pension, is to take their time to carefully review the information and options provided and get advice before they make any decisions about what they wish to invest in.
When you invest in a pension fund, a percentage of the money you invest each month typically goes towards equities, bonds, cash, property and alternatives.
It is the percentage that you decide to invest in each of these asset classes which will have the biggest impact on how your pension fund performs - not picking individual stocks or how well you time the market.
Apportioning this percentage is referred to as asset allocation and in the financial services industry, it is the tool used to maximize returns along with minimising risk and its importance is not to be underestimated.
But how does the ordinary person determine how much of their contribution should be invested in equities, property, cash etc?
There are formulae for asset allocation, but for me most are too simplistic. For example: one formula is to subtract your age from 100 and this is the amount that should be allocated to equities. But it doesn’t allow for the four major factors that influence what your personal asset allocation should be and they are:
n Your age (and health)
n Your current level of retirement savings
n What you would like your income in retirement to be
n Your risk capacity
For me the biggest factor of all is your attitude to risk. How do you feel about losing money?
Obviously no one likes it, but if you can tolerate losses in your fund then your tolerance for risk is high. But if a 5% loss would cause you sleepless nights, then you have a low capacity.
No matter what anyone says your level of risk should be, the amount you should accept is enough to obtain the returns you need while providing you with enough safety so you don’t sustain major long-term losses.
Not deciding things like their risk profile, or what income they need in retirement, and why they are investing X% in equities etc. is something people regret when they find later that they were investing in the wrong funds all the time, and they don’t have the time to make up for lost ground.
This happened to someone I came across about three months ago whose pension fund had reduced by around 12%, which in monetary terms, meant it was down by €28,000.
I asked him what he thought his attitude to risk was and he thought it was probably medium to low, but he wasn’t quite sure. When I looked at how his existing fund was structured, it showed me that about 85% of his fund was invested in equities, meaning it was set up for someone who had a very high appetite for risk; so it wasn’t aligned or suitable to his risk profile.
If it was suitable for his profile, he would still have lost money, but it wouldn’t have been €28,000, it would have been more like €9,000.
I asked him to complete a risk questionnaire for me, which took about five minutes.
This really is a great exercise for anyone and I would strongly recommend it, because it shows what you real appetite for risk is. And the results of the questionnaire only confirmed what he already thought his profile was.
The European Securities and Markets Authority (ESMA) risk rating methodology, which is used by all pension providers, uses a seven-point scale which is designed to rank an individual’s risk profile.
The higher the number on the scale, the higher your risk appetite is. This person’s number on the ESMA scale was a three which allowed us to identify what funds were considered a three as well
It helped us narrow down what funds he should invest in, so they were perfectly aligned to him.
I am not suggesting people should rely exclusively on the results of carrying out this exercise, but it is a useful exercise nonetheless.
Have this in mind when deciding what funds you should proceed with, rather than just guessing or picking a default fund.