Don't put your eggs in the one basket

The pensions industry needs to deliver on its end of the bargain with fund members, says Caroline Madden

A WOMAN in a swimsuit springs from a diving board, makes a perfect arc and sails downwards towards an empty pool. Just in the nick of time the pool miraculously fills with water, saving her from a nasty ending.

The arresting TV advert is just one of many tactics used by the pensions industry to shake workers out of their apathy and into providing for their retirement.

Any initiative that encourages people to start a pension is to be applauded. With the State contributory pension currently set at €223.30 a week, it's vital that people make additional provisions or else they will face a sharp drop in income on retirement.

But, having convinced people to place their retirement savings in their hands, the pensions industry needs to deliver on its end of the bargain.

This certainly isn't happening at the moment, and pension fund members now find themselves (to use the industry's own metaphor) with serious leaks in their swimming pools.

The current crisis raging in financial markets has hit pension funds hard. In fact, almost €10 billion was wiped off Irish pension funds in the first three months of 2008 alone.

However given the long-term nature of pension investment, this is most likely a short-term blip from which funds will bounce back in time.

More worrying is the fact that in the managed fund sector, (used as a yardstick for the industry in general) only one fund manager has outperformed inflation over the last 10 years.

With the Government currently toying with the idea of making pensions mandatory for employees, workers deserve a more compelling investment proposal than a negative real return over a 10-year time frame?

"We have to keep in mind it's a very unique 10-year period and, if you roll the window forward or back, let's say 10 years until a year ago or hopefully 10 years until a year from now, it'll be a very different picture," argues Deborah Reidy of Hewitt Consultants. "It just so happens that there were two very negative periods in that [10-year period]."

Fiona Daly of Rubicon Investment Consulting points out the generous tax relief available on pension contributions, regardless of the dismal returns. "The money that goes into your pension scheme is tax-free, so even though the returns on the funds might not have been great over the last 10 years, the actual return on your money relative to if you had saved your net income are still substantial," Daly says. "You have to lose a lot of money before it would actually wipe out the effect of the tax break."

Without doubt, the pension tax incentive is very attractive, but does that let fund managers off the hook? Surely the underlying investment should be attractive in its own right? Isn't that what fund managers are paid fees for?

Perhaps if the annual charges were more closely linked to performance, rather than being calculated as a set percentage of the value of the pension fund, customers would get better value for money. Despite the abysmal performance of pension funds recently, only one or two managers reduced their fees as a gesture of goodwill; it certainly isn't a hard and fast policy across the industry.

Hewitt's Reidy draws attention to a strange feature of Irish managed funds - the remarkable similarity between their asset distributions. Take for example their overexposure to the domestic stock market. Even though, the Irish market represents just 1 per cent of the global stock index, until the recent slump, managed funds typically invested 20 per cent of their portfolio in this sector. By December, the vast majority still held between 13 per cent and 16 per cent in Irish equities.

Reidy says that this lack of variation is due to the "herd mentality" that exists amongst the fund managers. She feels that they are more worried about underperforming within their peer group than making the best investment decisions. "In the managed category, I think it's very difficult to get any of them to be willing to take their eye off the group," she says. "It's the tail wagging the dog for sure."

Managed funds are the default option for many people, but what alternatives are out there for those who want a better return on their retirement savings? Except for the very wealthy, with the time and expertise to build up a sufficiently diversified portfolio, managing one's own pension is simply not a viable option. There are, however, several other alternatives.

Reidy says that a new approach to pension fund management known as "unconstrained management" is now emerging in the Irish market. It is less benchmark-focussed, and more akin to the investment approach taken in the private wealth management sector.

"In that category I think you would get some of . . . the manager's best ideas, rather than the asset distribution that minimises his business risk [as is the case with managed funds]," she observes. This approach is becoming increasingly popular internationally, and most Irish fund managers are already developing products that fall into this category.

Noel Collins, senior investment consultant with Mercer, feels that greater diversification is the way forward, with funds invested across a broad range of asset classes. This should result in lower volatility than traditional managed funds which tend to be predominantly invested in equities. He says that many Irish fund managers are beginning to take this approach on board, both in existing managed funds and new products.

According to Raymond McKenna, partner at Watson Wyatt, an increasing number of funds have emerged in the market in the last number of years that have removed "manager risk".

There are two risks associated with traditional pension funds - the risk that the stock market will fall, and the risk that the manager will pick the wrong stocks or mistime the market. Passive funds, such as consensus funds, remove the manager risk by mirroring the average asset allocation of other managers in the Irish marketplace.

As they aren't actively managed, the fees associated with passive funds are lower, and because the make-up of these funds tends to change less frequently, the transaction costs are generally lower too.

According to Fiona Daly of Rubicon, passive funds tend to "come in around the average of managed funds," so they eliminate the risk of choosing a managed fund that performs badly. "It takes out the potential of going with the best performer, but for a lot of people they're more worried about the downside risk," she says. Passive funds have grown dramatically in popularity in recent years and now represent approximately 28 per cent of the market, she adds.

"I don't think that people should have to just stick with the managed funds simply because that's the done thing," says Brendan Bartley, director of the Pension Solutions Group at Pwc. "There are other options out there." It is worth considering some of the many specialist funds now available from life companies, he suggests.

Another investment approach that can be beneficial is known as "life-styling". The conventional wisdom is that people should begin switching away from equities to safer asset classes such as fixed income and cash, five to 10 years before retirement.

Funds which offer a life-styling option do this automatically - younger members will have a greater exposure to equities. As they get closer to retirement, they will gradually be phased out of equities into more conservative asset classes.

However, what about workers very close to retirement who weren't offered a life-styling option, and didn't receive - or ignored - advice to reduce their exposure to the stock market? They don't have the luxury of time to recover from the blow dealt by the stock market in recent months. The argument that this is a temporary blip is cold comfort to people who find themselves in this unfortunate predicament.

According to Bartley, there is really only one option for those who got caught by the sudden fall in the market, other than simply taking the hit. Although he stresses that it is a "very, very drastic move", it might be worth considering negotiating the deferment of their retirement date with their employer. "Say if you're supposed to go at 60, could you defer that until your 65th birthday?" he suggests.

This is clearly an extreme move, and highlights the importance of people choosing an age-appropriate investment strategy, rather than chasing the equity gravy train in the hope that a stock market crash won't materialise before their retirement.