A few years ago, I saw an article that compared pensions with carrier bags – you could always take the cheap one that you might have to change to keep it up to date and suitable for your needs or you could get the so-called “bag for life” which would last or the longer term and all you would have to do is change the contents. Undoubtedly, it is the contents of the bag that are important but only if they are linked to a defined goal and amended as appropriate when the time horizon or goal changes.
Recent investment market volatility and some of the resulting media coverage means that active investment management and a well researched investment process are becoming more and more important, particularly in the run-up to retirement.
When retirement is a long way off, volatility is sometimes just something of a minor annoyance on the long-term journey – the received wisdom being that equity performance will balance out, given a long enough time horizon.
But what about when retirement is imminent?
In the past, life styling has been used to try to minimise the effect of volatility close to retirement, with some form of programmed switching out of equities and into cash or gilt-based investments. The fashion for many defined-contribution schemes has been to offer a default lifestyling profile, moving investments over a period of time by a given percentage each year.
Often this was geared to the normal retirement age under the scheme, typically 65 for men and 60 for women. These days, however, retirement is much more flexible, with the lucky few being able to retire early and many others having to consider retirement later than anticipated.
The choice of retirement option is also important – the growth of income drawdown under personal pensions means that some form of equity exposure is needed later in life to justify the choice of income drawdown over annuities.
So we are faced with the situation that some pension holders will have been lifestyled out of equities during the accumulation period of their pension, only to be faced with the need to get back into the markets to drive their retirement choice.
It is therefore important to consider a client’s specific retirement needs and likely retirement date some years before it happens.
Alongside this, a thorough understanding of the client’s attitudes to risk, their capacity for loss and the variables that can change a given set of circumstances are becoming essential.
In the future, retirement planning is likely to become a long-term process with changing investment needs at each stage – returning to my previous analogy, changing the contents in the revailing carrier bag.
At the beginning, and in the search for flexibility, income drawdown might well be the answer.
Several years of investment exposure and volatile markets could then take its toll and the client requirement might still be to enjoy the potential of market and investment upside but with the need to limit or even completely curtail downside. Innovation in the investment market now means that this is possible using specific funds designed with an investment floor.
It is also a growing feature of funds on the market to have ratings with regard to both risk and volatility – it is not just the likelihood of getting to the destination but also how bumpy the journey is going to be.
Many of these funds aim to provide a combination of growth and protection by shifting allocations between a diversified basket of mainly equity funds, called “risky assets”, and a group of money market instruments or bonds, dubbed “lower risk assets”.
The development of multimanager and multi-asset funds means that it should be possible to target a client’s attitude to risk and volatility in a much more controlled way and to be more accurate in that targeting.
As an alternative to dealing with volatility at a fund level, it could also be possible to “insure” the pension portfolio from further downside by adding a guarantee to all or part of the pension fund – the development of the third-way products. The final part of the retirement journey could well be the absolute security of income offered by the purchase of an annuity.
The focus of the FSA has recently been on risk profiling and the suitability of investments for a client’s needs and this is likely to continue.
Add to this behavioural research which has suggested that human nature means people fear a loss more than they enjoy a gain and I think that the need to focus more specifically on risk management will be high on the list of adviser skills in the future.
To stretch my analogy further, make sure that the contents of the bag meet the needs of the event for which you are preparing – a bit like Ready, Steady, Cook.