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- Stock markets will rise again as surely as they have fallen. Switching out of equities now would lock in losses.
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Employers must avoid knee-jerk reactions to the falling stock market’s effect on their pension default funds, says Ceri Jones
One sure thing about stock markets is that they rise and fall in cycles, and that selling out of equities now, when they are low, would almost certainly prove a poor investment decision in the long run. Employers or trustees making investment choices for defined contribution (DC) pension schemes should avoid knee-jerk reactions to the current stock market malaise.
But many employers will want to make sure the default fund in their DC scheme is being managed correctly. This is because default funds are often passive equity funds, or managed funds, which have a high component in equities and have been hammered by the summer’s stock market falls.
Mark Jaffray, senior investment consultant at Hymans Robertson, says: “The time when markets are falling is always the worst time to react. Not only is it the worst time to cash in equity investments, but also the worst moment to buy defensive assets such as bonds because they won’t be falling and will be expensive. These factors make switching now a double whammy.”
The best strategy to protect employees from volatility is to construct an investment portfolio with an array of assets that react differently to market conditions and do not rise or fall at the same time. In recent years, pension providers have been addressing this need by launching diversified growth funds that invest in a mix of uncorrelated assets.
The big problem is that these funds are expensive, with typical annual management charges of 0.6% to 1% compared with, say, 0.2% for a passive global equity fund.
Cost should not overshadow suitability
But John Lawson, head of pensions policy at Standard Life, says the cost of funds should not overshadow their suitability. “The industry needs better funds, not just cheaper funds, but the government and consumer bodies are obsessed with charges,” he says.
The higher charges of diversified growth funds mean trustees, sponsors and fiduciaries must be convinced they will deliver on their promises. Advisers who have modelled the funds’ past performance have found that they smooth volatility but slightly lag the best pure growth funds, a trade-off that is acceptable to most schemes. Some advisers put in more than one fund to remove some of the manager risk, generally mixing a vanilla diversified growth fund with a more aggressive one. These ‘stronger flavour’ funds may invest in unusual assets, such
as catastrophe bonds, forestry and litigation finance, which can be good hedges against falling stock markets.
Jaffray adds: “Absolute return funds have done well and we are comfortable introducing them, but there are challenges. As well as high fees, performance is reliant on the fund manager making tactical decisions."
Even diversified growth funds will hold 30-40% in equities. However, some structured products use derivatives to offer some for of guarantee, so gains made in bull years could be partially guaranteed and carried forward.
However, the fund would not enjoy full participation in any upside in the market.
Many employers will want to help staff who are close to retirement and whose pension pots have been hit. One coping strategy is to cash in only part of the pot and live off the tax-free cash for a few years, allowing the fund to recover.
Read also Keeping DC members aware of fund investments
Read more articles on defined contribution (DC) pension schemes