This article was first published on 27 July 2018
When it comes to financial affairs, there are three things at which we are ‘the pits’ – Pensions, Investing and Taxes. We have a morbid fear of all three.
Pensions are “complex and untrustworthy”
Investing is “like playing roulette at the casino
TaxeS are “best avoided at all costs”
But with the decline of final salary pensions and few people now buying annuities, we all need to get better at all three PITs and particularly investing. Why? Because our future retirement income will depend not only on how much we contribute to the pension fund (see last week) but also how our pension savings are invested.
In everyday life, we use the word ‘investing’ in the sense of ‘doing something now’ in order to “invest for the future”. For example, we might invest “time and effort” to build a better business, improve the house you live in or train your body to improve your sporting performance.
In the financial sense, “investing” is still about targeting an improvement; improving a financial outcome in the future. And as with most things in life, a successful outcome depends on you setting a target or objective in advance and developing a plan that guides your decisions while allowing for deviations from time to time.
There are two questions that you should answer before investing:
1. What is the “improvement” or Target Return that I am hoping to achieve?
2. What is my Investment Horizon i.e when do I need to do something else with the money I have invested?
One of the biggest investors in the world, CalPERS (the California Public Employees Retirement System) asks both these questions when managing its US$350 billion fund. In setting its 10 year plus target return it assumes an annual return of up to 7% for global equities..
If you look at similar assumptions made by three of the biggest investment managers in the world – Blackrock, JPM Chase and BNY Mellon – they make a similar assumption for an investment portfolio containing all the shares of companies listed on stock exchanges globally, that is a return of over 6% per annum over the next 10 years.
CalPERS is responsible for paying pensions now and in the future to thousands of retirees. So, in answering the second question, the Investment Office at CalPERS needs to plan not only to generate a good return on investments (say 5 – 6%) but also to have cash available at the right time in order to pay pensions. It will therefore invest to a greater or lesser degree in all the asset types mentioned in their chart above.
We don’t need to be as sophisticated as CalPERS when investing!
We should however draw the following lessons:
1. CalPERS would not invest $350 billion of public employees’ money in stock markets around the world if these operated like ‘casinos’.
2. Expecting a return of 6% per annum from equities over the next 10 years is not unreasonable.
3. UK cash deposit rates are significantly lower than in the US. Blackrock is assuming an average return of just 1% from sterling over the next 10 years.
4. Leaving your pension savings in cash is usually a poor investment decision.
We can rightly leave most of the detail to professionals. Our workplace and personal pension savings will be managed by an investment manager like Blackrock, JPM Chase or BNY Mellon. They decide on what shares to buy and sell and whether to invest in other assets like bonds and property. They will also assess short term risks and may deviate from the longer term plan by reducing or increasing exposure to equities.
But, asking yourself questions like ‘When am I going to retire?’, ‘How much cash, if any, will I need as a lump sum?’ and ‘Where am I going to invest my pension savings after retirement?’ require us to have a better understanding of investing and a willingness to question those who invest on our behalf. After retirement, choosing to leave your pension savings in an Income Drawdown account will only increase your need for investment knowledge. You will need a plan to both invest and to harvest retirement income from your account while allowing for flexibility as your circumstances change. No easy task!