TPAS - The Pensions Advisory Service

Investment

One of the most important choices you have to make in taking out a Personal Pension Plan or Stakeholder Scheme is how your money will be invested.

These types of scheme are provided by various approved bodies such as insurance companies, banks, building societies and investment companies. The all offer a choice of different types of fund in which to invest your payments. Your choice of provider may be influenced by the type of fund, or funds, in which you decide to invest. Another determining factor is the risk involved.

Risk

Risk is a measure of uncertainty. Those saving for their retirement, whether through a pension scheme or otherwise, face a range of uncertainties and need to have some understanding of these if they are to manage the risks involved. We will try to outline some of these under the following headlines which are not comprehensive:

Inadequacy Risk

Irrespective of the other risks involved, the greatest risk any saver faces is that their investments will be inadequate for the purposes for which they are saving. In the case of a pension scheme, this means that it does not produce sufficient income to provide you with the standard of living you wanted to achieve.

The elements which can give rise to this are;

• the contributions made to your scheme have not been enough,
• the return on your investments has been poorer than you had been hoping,
• inflation had been greater than anticipated leaving you in a situation where the purchasing power of your pension is less than you had expected,
• the annuity rates prevailing at your retirement provide less pension than you need.

Some( possibly all) of these elements are outside your control, e.g., future inflation, but others you may have some, albeit limited, ability to influence. It is you who decide how much you save. You should review regularly whether you are saving enough to meet your needs in retirement. Similarly you need to take an active interest in the performance of your investments and be prepared to make changes if the investment manager is not matching your expectations, provided those expectations are realistic. Finally, you may be able to influence the impact of annuity rates by being prepared to be flexible with regard to when you take your pension.

Investment Risk

Investment risk is the likelihood of your investment failing to fulfill your expectation of the returns you hope to achieve. This could be in terms of the income produced, the growth in capital value or both. Risk and reward tend to go together: the greater the risk, the higher should be the reward. However, this is not always the case.

The period of the investment is a determining factor; the shorter the period, the less likely that the greater returns will manifest themselves, whereas the longer the period of investment, the more likely that the higher returns will be realised. This means that higher risk types of investment are most suitable for those with a long period before the investment needs to be realised. In pension scheme terms this would mean a term in excess of 5 years although some commentators would advise that higher risk investments should only be considered by those with at least 10 years to retirement.

Currency Risk

When you invest overseas, in addition to the investment risk, you are also open to the additional risk that the foreign currency reduces in value against the £. This means that the value of your overseas investment also decreases when measured in terms of £s.

Not only can the overseas stock market suffer volatility but so also can the currency. Gains on the market may be reversed by falls in the value of the currency. The ideal situation would be that gains on the market are added to by an increase in the value of the foreign currency as against the £.

To reduce the currency risk you can use funds that invest in a range of overseas currencies and reducing the risk. Also some fund managers take measures to remove or reduce the currency risk, particularly at times when they believe the overseas currency is likely to fall in value relative to the £.

Types of Fund

Most providers will have a wide selection of funds from which you can choose. You do not have to put all of your money in one fund but can spread it over a number of funds.

The following is a description of how these funds work and the investment risks associated with them:

Cash Fund

These are simple deposit accounts, resembling building society and bank accounts, under which your money earns interest.

These funds are not generally suitable for long-term investment, as the rate of interest granted is usually low. However, they would be seen as low risk. They would normally be used in the following circumstances:

• where you are approaching retirement and want to take your money out of riskier investments in order to hold them in a low risk fund until you actually retire. In this situation, you might use a cash fund for up to a few years.
• where you believe the outlook for other investment markets, e.g. equities, are uncertain and you want a safe but temporary haven. In this situation, you may only intend to use a cash fund for a few months but, if markets are falling, you could end up using it for a few years.
• where you are exploring other investment options and haven't yet decided the longer-term placement of your money, a cash fund would be suitable for holding your savings for a short period.
• where you are moving money between funds but want to finesse the timing, you could hold your savings in a cash fund until you are ready to commit to a longer-term investment.
• where you are investing a large sum, e.g., a transfer from another scheme, you may not want to commit it all in your chosen fund at the same time but spread its placement over a period. In that situation you could hold it in a cash fund initially and then invest it gradually.

Bond Fund

Bonds are issued by UK and overseas governments and companies. Government bonds are usually referred to as gilts while those issued by companies are known as corporate bonds.

A bond is a loan raised by the issuer who promises to pay out interest at regular intervals, e.g. quarterly, and promises to repay the loan at a specific time or within a specified period.

Bonds may be attractive to investors who want to generate income. They can also be seen as low risk investments, particularly UK government gilts, which are seen as carrying little or no risk of not being repaid. Overseas government and corporate bonds may carry a higher degree of risk of default and should provide a higher return to compensate. Overseas bonds carry an additional risk arising from the fact that your investment is specified in a foreign currency, the currency risk.

There is an active market in bonds with investors buying and selling them. As investment rates go down, so the cost of bonds rise and as interest rates rise, so the cost of bonds decreases.

Equity Fund

Equity funds invest in the ownership of companies. Companies issue shares in their business and these are sold on the stock market. These shares are known as equities.

An equity fund will hold the shares of a variety of companies. Equity funds have produced good returns over a period of years. However, their short-term performance can be very erratic and a significant fall in value can be experienced. For most investors, equities are seen as a long-term investment.

The main risks associated with equities are that the value of the share may fall, ultimately to zero if the company goes into liquidation. By holding a wide range of different shares, an equity fund will reduce this risk.

The main risk for a pension investor is that the values of the shares in the fund have dropped at the point in time when you want to retire and draw a pension from your pension savings.

There are a very wide variety of equity funds available for pension investment. The more common types are:

1. Tracker Funds
   They try to mirror the performance of either a whole market, e.g. the entire UK equity market, or part of it, e.g. the top 100 shares.
   The attraction of this type of fund is that the risk element is reduced due to the wide spread of companies invested in. Also the charges for this type of fund are usually lower.
   The main disadvantage is that lower risk usually comes at a cost, in the form of a lower return.
2. Specialist Funds
   There seems to be an endless variety of specialist funds e.g. smaller company funds, large company funds, special situation funds, growth funds, income funds etc, all trying to give added value by concentrating on a particular area of the stock market or particular type of share. These funds would be considered high risk
3. Overseas funds
   These funds invest in the equity market of a specific country, e.g. USA, Japan, etc or in a particular geographical area, e.g. Europe, Pacific area etc. The nature of the funds could be the same as this previously mentioned, Tracker or Specialist.
   The tracker funds would work in the same way as the UK tracker funds and are an attempt to reduce risk. However, overseas funds have an additional risk that comparable UK funds do not. Because the investment is specified in a foreign currency, there is also the currency risk.

Property Fund

Property funds invest directly in commercial property, offices, shop, factories and warehouses. The value of units increase with the rents received from the lease of the properties and periodically the fund managers arrange for the holdings to be independently valued. To the extent that the valuations reveal an increase in value, this will lead to an increase in the value of the fund units.

Although property has provided good long-term returns, there are times when property values decline. In that situation, if you have need for your funds at such a point in time, you may it difficult to disinvest from the property fund. Even if you are able to do so, it may be at a considerable discount in the unit price.

Property also carries the risk that the particular investments entered into do no prosper, or at least not to the extent of other comparable investments. As with equity based funds, your investment performance is very dependent on the skills of those managing the specific investments within the fund.

Managed Fund

Managed funds are made up of a mixture of different types of investment such as equities, bonds and cash. Some managed funds will also include property and/or overseas investments. Spreading investment over a mixture of different types in this way, reduces investment risk. The thinking behind this approach is that not all types of investment will perform poorly at the same time. However, the skill of the investment manager is even more important in this kind of fund, as it is their ability to change the mixture from time to time that which will add value.

Lifestyle Fund

These are funds that take away some of the decision making with regard to what type of investment to use and when to change investment approach.

The approach of most lifestyle funds is that the pension scheme member should invest for growth when they are young and far off retirement. This means investing, mainly or wholly, in equities. As retirement draws near, investment is gradually switched away from equities to fixed interest and cash.

Most lifestyle funds make the change from an aggressive investment approach (normally equities) to a conservative approach (fixed interest and cash) on a mechanistic manner rather than according to prevailing market conditions. Thus the switch will take place over a fixed period of time, eg, the 5, 10 or 15 years before the investors selected retirement age. This switch will happen automatically, even if market conditions at that time are unfavourable, unless the scheme member intervenes to prevent this.

Care should also be exercised by those who adopt lifestyle funds but then change the date at which they decide to retire - at the new date of retirement, the fund may be in inappropriate types of investment.

With Profit Fund

Insurance companies normally run this type of fund. The money in the fund is usually invested in equities, bonds and cash. Investors buy units in the fund. The capital value of the units doesn't fall even though the value of the underlying investments may fall. To allow this to happen, a reserve account is built up when investment returns are good. The reserve account is drawn on in periods when investment returns are poor. The value of a unit increases each year subject to the performance of the underlying investments and the ability of the manager to release part of the reserve account. If the performance of the underlying investments is poor, there may be years when the value of units does not grow.

This type of fund has been seen as low risk. However, the performance of many of these funds in recent years has brought about a new appraisal of their risk rating. This cannot be divorced from the nature of the underlying investments and the size of the reserve held. If reserves are low and the underlying investments are high risk, e.g., equities, then the risk profile of the with profits fund will also be high risk.

Another problem with these funds is the ability, written into the documentation, for the fund manager to levy a charge should the investor wish to encash their units at any time other than their selected retirement age. This charge is called the Market Value Adjustment and is intended to reflect the fall in value of the underlying investments since the investor bought their units.

Default Option

Many pension investors find it difficult to take an active involvement in the investment of their own monies and so many providers offer a default option into which pension contributions are invested when the investor is unable or unwilling to make a choice of their own. It is a requirement of all stakeholder schemes to offer a default option but many personal pension plans do not.

Some providers use their lifestyle fund, some use their managed fund and others adopt a more conservative fund such as with-profits or fixed interest.