I have just had a conversation with a member of a workplace pension scheme who asked me to explain the terms above which were all muddled together in a provider’s literature. The question was “what do they mean and why should I be bothered?” Fair enough; it is a good question!
Risk and Reward
Let’s start with the building blocks of all long-term investment, risk and reward. Investment is never about a guaranteed fixed return, investments are always uncertain, but to say an investment is ‘high’ risk is to suggest that the range of potential returns is wide, from losing all of your stake money to the equivalent of winning the National Lottery and the chances of any particular outcome is uncertain. Conversely, a ‘low’ risk suggests a quite narrow range of likely outcomes and some certainty of what will ultimately happen.
As a general expectation, the more risk an investor is being asked to take, the more reward, “profit”, the investor will expect to compensate. The decision for the investor, (and their adviser, if they have one), is whether the risk of a poor outcome is worth the potential reward. If it is not “worth the candle”, then you would not invest.
Going “too safe” is also a problem; inflation is the elephant in the room, stealing your buying power over time. The times have long passed where £2,000 per annum was a good income and you could buy a new car for under £500. The Bank of England inflation target is 2% per annum, so even if everything goes to plan the value of your cash will halve every 35 years. The August 2017 RPI figure was 2.7%, which would halve your money in 29 years.
As a gross simplification, there are three major asset classes, cash, stocks and equity; with cash considered to be “safe”, stocks to be middling and equity to be “risky”. Within each asset class, there is considerable variation; with cash, contrast the access and security of ten pound notes concealed in your mattress with a deposit account held by a well-capitalised international bank, guaranteed by H.M Treasury. For stocks, think of the differences between UK government gilts, loan notes issued by a UK water company plc and a debenture offered by a foreign information technology start up. For equities, think of the difference in likely outcomes between a UK “Blue-chip” FTSE 100 share and a Chinese start-up share only available from a regional share exchange.
Now, no one sensible will hold only one asset in one asset class; just having cash under the mattress makes you vulnerable to burglars, so within each asset class you need some diversity. For cash, I would suggest some in your pocket, a small balance in the bank current account, an emergency fund in a deposit account or cash ISA, with any additional cash in a different bank. For equity exposure, you don’t just have a shareholding in one company, but shares in many companies, industries and geographical locations. Modern portfolio theory emphasises “time in the market” over “stock-picking”, so this is where advisers can add significant value.
As a general observation, as you get older, you tend to take fewer risks in life. “Lifestyling” is an investment process some pension providers offer where investments are de-risked systematically as you get nearer to the planned retirement date, with the proportion of cash and bonds increasing and the equity exposure reducing. If you are buying an annuity on a specific date, then this process is suitable as you will need to have cash to buy the annuity and a value drop just before purchase would be disastrous. If your retirement plans use drawdown, then lifestyling is probably not a suitable strategy as you need to be investing for growth and income, long term, not a cash-out on a specific day.
Pension Freedoms has massively increased the number of people who are accessing drawdown, so many pension savers will be in lifestyled funds that were a rational choice when they joined the pension scheme, but are now working against their objectives.
There is not much special about “pension investment”; it is just investment for a specific purpose but before retirement, the priority will be asset growth over natural income. As all investment within a pension is free of income or capital gains tax, the type of growth/return is immaterial.
The key message for pension scheme members is that their retirement fund is a product of more than one factor, so all those factors need to be optimised for the best result.
Fund Value = Own premiums + tax relief + Employers premiums – charges + investment returns
This suggests a huge number of questions that all pension members need to think about:-
Can you afford to pay more into your pension?
Have you claimed the additional tax relief, assuming you are a 40% tax payer?
Can you get your employer to pay in more? Perhaps as “salary sacrifice” or as an alternative to a larger pay rise?
Can your adviser suggest any ways to squeeze out any more costs? Perhaps cheaper funds, passive over active funds or own brand funds over external funds?
Is your investment mix correct? Does it reflect your actual attitude to investment risk?
If you would like to know more about how we can help you plan and realise your financial goals, then contact us at firstname.lastname@example.org or call us on 01223 792 196.
The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly, no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.