The best way to build your nest egg
Anyone considering what to put in their pension is faced with a truly overwhelming choice of funds and asset classes.
Most personal pension providers offer upwards of 50 different funds, and if you have chosen a self-invested personal pension (SIPP) wrapper you can also invest in a wide range of other asset classes, such as shares, investment trusts, exchange traded funds, property and commodities.
These days, investors also have access to instruments that previous generations could barely have dreamed of, such as capital-guaranteed structured notes, funds of hedge funds and private equity investment companies.
The first questions a financial adviser will always ask are designed to assess the level of risk you are comfortable with, which will depend on your total wealth, health, years to retirement and other financial commitments.
Those who want to manage their own portfolios will have to examine their attitude to risk themselves, being honest about how much money they would be prepared to lose and what motivates them financially.
Choose the right approach
The traditional approach to designing a portfolio is to split your cash between a variety of asset classes to make a portfolio that matches your attitude to risk.
'Low-risk' investments start with cash and investment-grade government bonds, and move up the risk scale to corporate bonds and blue-chip shares.
At the riskier end of the spectrum are assets such as high-yield bonds, small company shares and alternative assets such as commodities, hedge funds, and private equity, which operate in less perfect markets and therefore offer greater scope for the manager to add value and generate an attractive return.
Ironically, a mistake inexperienced investors often make is to classify themselves as low risk and then invest in low- return cash or money market funds, unaware this will have a devastating impact on their pension fund's growth.
Most portfolio construction is based on the theory of diversification, that as one asset's price falls, another will rise to compensate.
In the financial crisis of 2008, however, the correlation between asset prices began to converge and prices fell together. Consequently, experts increasingly dispute the value of diversification, although it is still generally used as a starting point.
The best advisers are now calling for a more nuanced approach to asset selection, examining assets at a more granular level so accurate predictions can be made about their behaviour under different economic circumstances.
That might mean, for example, breaking down the BRIC funds into their constituent parts, and seeing Brazil and Russia as principally commodity producers - very different from India and China, which are commodity consumers.
Arguably, the desirability of a true international portfolio in modern markets, where most growth comes from emerging nations, makes a multi-asset portfolio the obvious choice, with a professional moving your money between assets as opportunities arise.
There are two ways this can be achieved - either as a balanced multi-asset fund that invests directly in a range of asset classes, or as a manager of manager arrangement, where your fund manager constructs a portfolio by buying into a range of underlying funds, and the skill you are buying is his ability to select the best ones.
Global multi-manager portfolios that are in the top 10 over one year include Investec Managed Growth and Henderson Global Strategic Capital.
The managed pension fund universe is further split between the balanced managed sector, where funds must comprise no more than 85% in equities plus an element of fixed interest to reduce volatility, and the cautious managed sector where funds can only hold a maximum of 60% equities, with at least 30% in cash and fixed income.
Examples of respected funds in the balanced managed sector include CF Miton Special Situations, CF Miton Strategic Portfolio, AXA Framlington Managed Balanced fund and Baillie Gifford Managed Balanced fund.
In the cautious managed sector good examples include Henderson Multi-Manager Income & Growth, AXA Global Distribution, and HLL/Invesco Perpetual Distribution Pension.
For more aggressive funds, the active managed sector allows up to 100% to be invested in equities and includes Jupiter Merlin Growth, M&G Managed Growth and CF Ruffer Equity & General.
Another way to achieve international spread is through global investment trusts, which are often touted as an efficient way for small investors to obtain equity exposure.
Quoted on the stockmarket, these trusts invest in shares of other companies and have low annual management charges - often about a third of the equivalent unit trusts.
Two of the largest, Foreign & Colonial and Witan, are both steady performers and have risen 15.5% and 14.5% respectively in the last year.
"There are so many different funds and options, investors can be paralysed by choice," says Andy Brown, head of asset allocation at Prudential.
He generally recommends two or three managed or multi-manager funds so that there would also be some diversification by manager style.
"The additional charging of a multi-manager fund will be worthwhile," he claims, "because although an individual may be able to buy the underlying funds more cheaply, genuine expertise is required to know when to go in and out of funds."
Correctly timing the market
Another trend that has quietly come back into fashion among institutional investors is trying to 'time' the market - that is, attempting to pick certain investments at a point in their cycle before they start rising.
Many top-end consultants have come full circle and are now advising their high-net-worth clients into 'dynamic' and 'tactical' asset allocation funds that switch between assets opportunistically, such as the Aviva Investors Absolute Tactical Asset Allocation fund and Schroder ISF Global Tactical Asset Allocation.
A lot of research has been conducted on unconstrained mandates, which allow the manager greater freedom to stray from the benchmark, suggesting such funds deliver better returns.
The range of approaches is endless, but another established strategy for investors with fairly large pensions is to have a core portfolio in a low-cost passive fund, such as an exchange traded fund, perhaps with global exposure, such as the iShares MSCI World Index fund, and then to add four or five racier satellite funds or assets to deliver outperformance.
These satellites might be active portfolios where you expect to make high returns, such as emerging markets or funds of hedge funds, where you feel a manager has the skill to exploit discrepancies in an imperfect market, but they could equally be passive plays on markets where you think there is a long-term secular bull trend and emerging economies would be an example of this, too.
Making poor decisions in choosing funds can be expensive. According to Financial Express, the best holding in an unfettered life assurance pension fund over the past five years is BlackRock Gold & General fund, which made investors a return of 183%, while the worst is Legg Mason Japan Equity, which has lost 65%.
The huge difference in this case is largely a function of the respective regions. Nevertheless, the best pension balanced managed fund over the same period is Friends Provident Newton Balanced, up 58%, while the worst is Framlington Corp Pension Fund, down 12%. It is important to note that the differential can be great within the same category.
Certain pension providers have limitations. Ben Willis, head of research at Whitechurch, which runs an interesting income distribution portfolio for post-retirement portfolios, says he sees clients who have had a SIPP wrapper with a bank, where there has been no ongoing service or changes made to the portfolio.
"Banks use a lot of in-house funds and the question for investors is whether they are getting best of breed," Willis says.
"Banks also have a tendency to invest directly in equities, because individual share-broking is their traditional specialism. This is not suitable for cautious investors."
He has also seen portfolios where as much as 40% was in structured products, but personally prefers to cap such exposure to 5% of a portfolio, owing to counterparty risk.
Your portfolio should be reviewed regularly. If a portfolio is left unchanged for years then rising markets will normally boost the equity holding and increase investment risk.
As you approach retirement, your pension should gradually switch to less volatile assets, but not the whole portfolio and not too soon.
In the two years before retirement, you may want to ensure you have sufficient liquidity in the portfolio to take your entitlement to tax-free cash of up to 25% of the fund's value.
However, if you move into income drawdown on retirement, the capital value of the pension must not be eroded or maintaining your level of income will be difficult.
It is important to maintain some exposure to equities as well as income-producing assets such as government and corporate bond funds.
Currently there could be a lot of value in dividend-paying blue-chip shares as many of these big companies were left behind in the last rally.
"Whether it is a post- or pre-retirement portfolio it is important that the portfolio is aligned to the individual's attitude to investment risk, time horizon and income requirements," says Sarah Lord, wealth planning director at Killik & Co.
A useful questionnaire to determine your risk appetite can be completed online at Legal & General's website (http//landg.kisshosting.com/corporate-pensions/atr/nonflash/questions.htm).
This article was originally published in Money Observer - Moneywise's sister publication - in November 2010
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
Investment funds that invest in other investment funds from a wide range of asset managers and are often referred to as funds of funds. Some multi-manager funds only invest in the funds of the investment house providing the fund of funds and these are known as “fettered”. An “unfettered” multi-manager fund is free to invest in what the fund manager believes are the top performing funds from across different markets and industries. Investing in multi-manager funds means your risks are spread across geographical regions and industry sectors but it also adds another layer of charges and some multi-managers also levy an out-performance fee.
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An acronym, which stands for Brazil, Russia, India and China; countries all deemed to be at a similar stage of advanced economic development. The term was coined in 2001 in a report written by Goldman Sachs director Jim O’Neill who speculated that, by 2050, these four economies would be wealthier than most of the current major G7 economic powers.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
Generally thought of as being interchangeable with insurance but isn’t. Assurance is cover for events that WILL happen but at an unspecified point in the future (such as retirement and death) and insurance covers events that MAY happen (such as fire, theft and accidents). Therefore you buy life assurance (you will die, but don’t know when) and car insurance (you may have an accident). Assurance policies are for a fixed term, with a fixed payout, and unlike life insurance have an investment aspect: as a life assurance policy increases in value, the bonuses attached to it build up. If you die during the fixed term, the policy pays out the sum assured. However, if you survive to the end of the policy, you then get the annual bonuses plus a terminal bonus.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).