A short guide to risk

Investment professionals are taught that pension savers face four main risks: the risk that they have less to retire on than they expect or need (shortfall risk), the risk of capital loss (capital risk), the risk of their investments not keeping pace with interest rates (interest risk) or of being eroded by inflation (inflation risk).

There are a variety of other risks - lifestyle changes, mortality improvements, regulatory or tax revisions – which may also impact on the main high-level risks. But often, rather than exploring these risks in detail and at length, all risks are simplified into a single assessment called ‘appetite for risk’ (normally on a 1 to 5 or low to high scale) expressed over a period of time.

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This is understandable because clients often have no idea what investment risks are and advisers do not have the time or tools to properly explain it to them. As a result, clients work their way into simple risk categories that best approximate their status.

When it comes to corporate pensions, the issue is no better understood. An individual member of a money purchase or defined contribution scheme often has little guidance when self-assessing or being assessed on investment risk – which is again interpreted as a single risk factor rather than multiple factors. The same is true of a corporate defined benefit pension trust client, where an additional unique risk – funding risk – exists. It tends to be only trustees of the largest, multi-billion pound schemes where the concept of risk is explored in depth. So how could risk instead be approached?

Like almost everything in financial services from bond yields to hedge fund strategies, what seems complex at the outset rarely is when broken down into its component parts. With risk,the first point to explain is that, while investing involves risk, not investing does as well. There are a variety of risks that we all undertake and accept, willingly and consciously or not. Accepting that we cannot avoid all risks, the question is: which do we concern ourselves with most? For a member of a money purchase pension scheme, the chief risks are the shortfall risk and the capital risk.

Given a time horizon of 20 years, which risk is more important? This is the key question that the client must decide, but logically you might expect shortfall to matter much more than capital risk.

What determines the outcome of any capital risk? Investment returns, inflation, contributions, personal health and future market interest rates (i.e. gilt yields). By making sensible assumptions about the risks that the client has no control over – market rates and health – the client is in a position to make a decision about the balance between investment returns, contribution rates and capital risk. They may choose to maximise investment returns and capital risk in return for lower contribution rates. By doing so they exchange high capital risk for low shortfall risk, and, if they cannot afford higher contributions, this may well be the right strategy for them.