Robert Pemberton goes through the issues advisers need to bear in mind when putting together long term investment strategies
Personal circumstances dictate that there is no 'one size fits all' solution for pension portfolios since an individual's own risk tolerance and time horizon are paramount in determining investment choice. Nevertheless, two crucial factors are at play in endeavouring to maximise risk-adjusted returns from retirement planning - tax mitigation and a robust investment strategy.
For high earners tax mitigation will likely involve the use of vehicles such as Enterprise Investment Schemes (EIS), Venture Capital Trusts (VCTs) and Enterprise Zones (EZs) as well as pension contributions. These are specialist structures with an ever changing legislative background. Increasingly widely used, particularly by those with relatively large pension pots, are SIPPs. A SIPP is a DIY pension in a tax efficient wrapper offering a very wide and flexible choice of investment. Therein lies the rub, you are managing your own portfolio and so need to formulate an investment strategy that will meet your long term aspirations. Given how markets have performed over the last decade this is no easy task.
Investing in the 1980s and 1990s was in retrospect easy. Economically it was a time of falling inflation and interest rates and you only needed to invest in two asset classes, equities and fixed interest, both of which fortunately produced strong positive returns most of the time. This two asset approach still dominates investment thinking in many institutional pension funds, a stance which is nostalgic and flawed. Inflation, changing shifts in the balance of global economic growth and more sophisticated, but potentially dangerous, investment techniques dictate a more flexible approach
Academic studies have demonstrated that 90% of portfolio returns comes from asset allocation, so there is an imperative to get this right. The asset management industry is indebted to Modern Portfolio Theory which won its author Harry Markowitz a Nobel Prize. Fortunately, unlike most theories from the 'dismal science', it's easy to understand, makes intuitive sense and most importantly works. It demonstrates the benefits of combining a number of assets in a portfolio in such a way as to achieve a high level of diversification (not putting all your eggs in one basket) and non-correlation (you want your assets to move independently of each other, possibly even in different directions). The aim is to maximise returns for each agreed level of risk so as to produce consistent, smoothed returns over long time periods.
It is important to realise that investment always takes place in an environment of uncertain outcomes (i.e. risk) and that different assets have different risk and return characteristics with higher prospective returns carrying with them a higher level of risk. Over the longer term equities have produced the highest real (i.e. inflation adjusted) returns any asset class of 7% per annum historically but with this comes a higher risk of loss. Timing your investments is difficult. Putting your entire pension fund into UK equities at the end of 1999 would leave you still counting the losses. Fixed interest returns have given lower real returns (approx 2.5% per annum historically) but less sleepless nights. Property was of course the new panacea averaging double digit returns over the last decade but just as everybody was espousing 'my property is my pension', commercial property values began a steep downward decline closely followed by the residential market. Gold has been ignored by investors until very recently yet has tripled in this decade. The moral of the story - attempting to call the markets tactically is a mug's game with 'professional' fund managers rarely any better than the man in the street.
As well as understanding the risk/return attributes of different asset classes it is important to understand correlation i.e. their relationship with one another over long time periods. Typically, most global equity markets move in the same direction and often with similar magnitude. Diversifying a portfolio between US, UK and European equity markets is a diversification of currency (an additional risk you may not wish to take as a £ based investor) rather than a diversification of equity markets. However, over long periods property has no correlation with equities (i.e. they move completely independently of each other) so any movement either together or in the opposite direction is merely a coincidence. Gilts have either a low or negative correlation with all other asset classes while gold traditionally demonstrates a strong negative correlation with fixed interest (one asset is an inflation hedge, it is anathema to the other).
More than diversification
It is important to realise that diversification in itself is not enough, as the last twelve months has shown, and you need sensible active management to enhance and protect your portfolio.
A few 'rules of thumb'
- Be clear in your attitude to risk to ensure that your chosen asset allocation is aimed at meeting your long term aspirations
- Play the long game and be strategic rather than tactical. Be prepared to make a few market calls in your asset allocation, but only to the extent that they do not undermine the long-term risk-adjusted strategy.
- Use a wide range of assets. Alongside traditional long-only assets (equity and fixed interest) have holdings in 'real' assets such as property and commodities and consider small exposure to new asset classes such as non-securitised asset backed lending and senior life settlements.
- Always seek long term value and remember there is a price for everything. An investment idea is rarely compelling when it has performed strongly and is being heavily promoted in the media and by asset management companies.
- Don't be scared of illiquidity in asset classes where it is appropriate such as property and private equity. Sacrificing liquidity (not an issue in a pension portfolio with a long-term time horizon) allows greater potential returns.
- Use strategies that increase the risk/return profile of your assets such as fund of hedge funds and structured products.
- Use smart people to manage your money. Search out the best managers of collectives (OEICS etc) for the underlying assets. If you are not confident of finding the right managers then consider a low cost ETF (index fund).
- Markets are constantly changing so put in place a process of monitoring and review.
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Retirement Planner Forum 2019