Pension planning needed to guard against unpleasant shocks

Ongoing oversight is the key to making hard-earned savings go further in retirement, as experts say the traditional “set and forget” approach to pension planning is no longer guaranteed to deliver optimal returns. With rock-bottom interest rates set to below the inflation rate for years to come, and euro zone bonds offering low yields, the conservative side of a classic balanced portfolio is no longer such a sure bet.

But the equity markets have suffered too. Pick from China’s market crash, the fall in oil prices, or events such as Brexit to cause many investors with itchy trigger fingers to jump ship.

An analysis by JP Morgan of 20-year annualised returns between 1996 and 2012 found that investors saw an average return of just 2.1 per cent whereas inflation was 2.2 per cent and the S&P 500 was 8.2 per cent.

Having a long-term plan – and the staying power to stick to it – is a critical element in minimising the risk that retirement savings will be diminished over time, according to Ian Quigley, head of investment strategy at Investec Wealth and Investment. “There’s evidence to show that the average investor massively underperforms everything because they’re jumping out all the time,” says Quigley. The lesson is not to be swayed by temporary market volatility. “What’s happening is, people let sentiment influence them but having a proper savings and investment plan should prevent this from happening,” he says.

The key to carefully managing a lifestyle savings and investment portfolio is to set appropriate goals at the start, Quigley says. “For most people, the most important thing is getting the asset allocation right, and that is going to be a function of each investor’s time horizon, and their financial capacity to invest,” he says.

Starting saving as early as possible is also the best way to withstand short-term fluctuations in equities. Quigley says that US data shows the probability of earning a positive return over a 20-year timeframe is 100 per cent, whereas for a day it’s just 52 per cent. “That’s why time horizon is so important. It’s from five years on that the probability ramps up past 80 per cent. If you’ve got a reasonable time horizon, and you’re well diversified, you’ll be fine.”

Unpleasant shocks

The profile of a savings plan needs to change over time, both to guard against unpleasant shocks and to protect lump sums for when they’ll soon be needed. The traditional savings split of 60 per cent in equities and 40 per cent allocated to cash and bonds has its limits in those kinds of scenarios, says Des Lawrence, senior investment strategist with State Street Global Advisors.

“As you go through the phases where you start to draw down a savings and investment portfolio, the enemy is a big correction like the recent financial crisis or the technology bubble of 2002. ‘Set and forget’ doesn’t work because you can suffer horrendous losses,” warns Lawrence.

Many investment advisers are now offering strategies that are designed to adjust over time in order to provide the maximum benefit when the time comes for savers to start drawing down those funds. “If someone is 25 or 30, it’s suitable to have an allocation to riskier assets like equities but if someone is coming close to retirement, and a crisis emerges, they can have a significant loss without time to recover. So in later years, it’s more suitable to get into more diversified and bond-like assets. For people with shorter investment horizons who don’t have the luxury of waiting 10 years for a recovery, it’s possible to set the level of risk in the portfolio to the market environment at the time,” says Lawrence.

The advantage of setting up a savings plan in a predefined structure is it removes the “behavioural bias” that causes people to panic. The immediate aftermath of the UK’s EU referendum doubtless caused jittery investors some sleepless nights, although Lawrence points out that the post-Brexit atmosphere calmed quickly.

Best option

In the current low-yield environment, equities still seem like the best option to achieve reasonable levels of growth, but this approach also comes with the risk of losses. “People are having to embrace more equities in order to get their return but that can give you a nasty shock. One way to manage that is to set a particular risk target on your equity portfolio,” says Lawrence.

You want to use that strategy to avoid the big dips, without responding to every little market wobble. Even a portfolio that’s got 50-60 per cent in equities will drive about 90 per cent of total portfolio risk, so it’s important to managing the equity part of that right.”

Lawrence also urges investors not to focus purely on the landing point or the retirement date alone. As people live longer, they will need their savings pool to go further into their retirement, and they should factor this into determining an ongoing risk-aware investment strategy.

“It’s a very interesting dilemma. The reality is, we want income and it’s easy to focus on that but you can still have a certain degree of risk – for example, that 30 per cent in equities will drive about 80 per cent of your portfolio risk. It’s better to have that dynamically managed so that is done properly for investors,” he says.

The Pensions Authority does not give specific advice but urges consumers to think about their goals for retirement, to start planning for them as early as possible, and to monitor their pension schemes closely during their lifetimes.

“You need to be engaged with your pension because it’s your future,” says David Malone, head of operations and communications at the Pensions Authority. The most important thing is to start as early benefit from the compound interest that accrues over as long a period as possible. “Pension saving is a long-term process over 30 to 40 years, and as you come closer to retirement, you need to start looking five or 10 years out, to see what options you have. It takes ongoing oversight.” On that point, Malone urges savers to put their annual pension report under close scrutiny. “Just as many people get a car insurance quote or your TV package and go through it with a fine-tooth comb, you should do the same with your pension statement every year,” he says.