All style and no substance?

The relationship between risk and reward is one of the least understood concepts for investors. Even relatively well educated investors often attempt to ameliorate the risk through one risk management mechanism or another.

But do such risk management strategies actually help, or is this just an illusion? In one particular aspect of financial planning this is a highly critical issue. Numbers of money purchase (defined contribution) pensions are set to rise massively over the next two decades and clients with these schemes, who are approaching retirement, are often ill equipped to make the right investment choices.

While most members of money purchase schemes would like to take no risk at all with their pensions, the reality is that, without risk, benefits at retirement would be a fraction of what they could be. An investment of £1,000 pa over 30 years accumulates to less that £50,000 with a net 3% pa growth rate; an 8% pa net annual return, on the other hand, accumulates over £120,000, a 140% improvement.

Risk means reward

But psychologically the concept that more risk means more reward, not less, can be quite challenging for many clients. One way to help scheme members adopt a more appropriate investment strategy is to encourage them to select lifestyle investment options. These start with high equity exposure and progressively reduce this on the run up to retirement.

Such encouragement tends to be achieved through offering this as a default investment option within the scheme. More than 80% of members of money purchase schemes are in default funds according to recent research, and a growing proportion of the default funds on offer now follow this approach.

If the US is any guide to the future we will see individual funds being designed to achieve this transition, known as target date or lifecycle funds, which have specific time periods and a target year for maturity. The idea is that the member decides when he is going to retire and then selects the appropriate fund for that time period.

In theory this takes all the hassle out of the issue, with no further decisions, and keeps life simple for scheme trustees, who can reduce their exposure to potential claims. Major exponents of this approach include Fidelity and Vanguard, the large passive fund manager.

Sure way to lose money

However removing all ongoing human interaction raises other issues. The predetermined progression from equities to lower risk assets sounds fine in theory, but what if equity markets have just nose dived? Selling equities after a major fall is, of course, a sure way to lose money.

Markets are cyclical and as we have seen twice in the past 10 years sharp falls are often followed by strong periods of investment growth. If market exposure is reduced during the recovery the result can be the opposite of what was desired as shows. This is based on two funds, one an equity index tracker and the other a notional fund generating a fixed return of 3% pa over the past 10 years.