Q&A

An Irish Times guide to the world of personal finance

Mutual funds and bonds

I have some savings, which I want to diversify because I am retiring soon. Could you please explain what: a) mutual funds; b) bonds are?

Mr J.C., e-mail

Mutual funds are essentially portfolio funds containing a mix of stocks, bonds, property and cash, which are run by fund managers on behalf of a pool of investors. There is, it sometimes seems, a bewildering array of funds and they all differ slightly. Some will have only one of the four investment classes listed above, others a mix of two or more. Those with a higher proportion of equities are considered higher risk and, within this, there are those which concentrate on the higher-risk end of the equity market, such as the volatile technology market, which can yield rich rewards and dramatic losses. Some are actively managed - that is the fund manager picks his stocks or other investments personally to try and beat the performance of the relevant broad index - while others passively track a particular index, buying shares in proportion to their weighting in the index to match its performance.

The investor buys into the mutual fund at a price that is set by dividing the assets of the fund by the number of shares held in it. Thereafter, the investor tends to pay an annual management fee, which varies from fund to fund and will be higher for actively managed funds. There is constant argument about the merits of active versus passive funds, but experience tends to show that while individual fund managers can beat the average for a period of time, over the longer term, the index wins out. Having said that, passive funds will never match the index when charges and fees are taken into account.

In order of risk, equities are at the top, followed by property, government bonds and cash. The higher the risk, the higher the potential gain; on the flip side, there is a greater chance of losing your investment. People such as yourself, who are looking to diversify savings in retirement, should be wary of adopting too high-risk a portfolio strategy as, nature being what it is, you have less time to recover from losses.

Turning to bonds, there are different classes of bonds, each carrying a different level of risk. The ones with which we are most familiar are government bonds or gilts. The latter term refers to the fact that such bonds are gilt-edged or secure because they are backed by the State.

Put simply, bonds are loans - to the State or a company - generally for a set period of time with an interest rate (or coupon) set at the outset. Bonds can be traded and their value will rise as general interest rates fall and vice versa.

The other class of bonds is corporate or company bonds. These work in the same way but are not backed by the security of the state. As such, they are inherently more risky. Corporate bonds carry various levels of risk and are rated by the likes of Moody's, Standard & Poor's or Fitches rating agencies. The lower the rating, the higher the interest rate the company will have to pay the lender to attract their money, as the risk is greater that they will default on - prove unable to pay back - the loan. At their worst, corporate bonds are termed junk bonds. These carry the highest risk of default and, conversely, the highest potential rate of return.

Corporate bond rating can change rapidly, especially if they find themselves in trouble, and investors can buy highly rated bonds only to find them tumbling to junk status.

In general, small private investors will only be able to buy bonds indirectly through intermediaries, generally as part of a mixed portfolio fund.

Pensions

I would appreciate if you could tell me what legislation says that a person employed for over five years (I've been a contract employee for six years) must be included in the company occupational pension scheme & membership of same scheme backdated to time they joined the company.

Ms M.B., e-mail

The legislation to which you refer is the Pensions Act 1990 but it has now been superseded by the Pensions (Amendment) Act 2001. The term covering the area to which you refer is vesting and, as you say, until recently the "vesting period" was five years. This meant that, if you were employed by a company under terms that made you eligible for an occupational pension scheme run for employees of that company, you had to be granted membership of the scheme five years after you joined. Your membership, as you say, was then backdated to when you joined the company.

Of course, companies could grant one entry to the pension scheme ahead of the five-year limit set down and many did. However, in general, the five-year vesting period laid down by the legislation was observed. The idea was that membership of the pension scheme was available only to those who showed their commitment to the company by staying a minimum of five years.

The latest legislation takes account of changes in working practice and general improvements in pension coverage by reducing this vesting period to two years.

However, vesting is not your only problem. There is also the issue of eligibility. Occupational scheme membership was generally reserved for full-time employees; as a rule, contract employees found themselves outside the fence. Of course, it depends on the rules of the particular pension scheme in your employment but it is likely that your contract service would not qualify you for membership of the scheme.

The good news is that that situation looks like changing. Under part-time workers' legislation coming into force, part-time workers - including contracts - who carry out the same functions as their full-time colleagues are entitled to the same rights and privileges. This would, it seems logical, include access to the occupational pension scheme for those contract workers working full-time for at least two years alongside their full-time co-workers.