Advisers have a wealth of risk profiling and asset allocation tools at their disposal to help choose from the broader choice of asset classes now available to investors
Risk profiling, asset allocation and fund selection are not a one-off exercise but require continuous assessment. While advisers have made considerable progress in providing these services to individual clients, the big challenge we now face is applying theory and practice to group schemes where cost considerations may prohibit the provision of ongoing advice to individual members. The availability of a streamlined IT service incorporating the features outlined in this article could enable advisers to place individual or appropriately grouped members of the company schemes they implement on a similar footing to their private pension clients.
The client's risk tolerance in relation to the investment term is the key driver for pension fund asset allocation.
The adviser's objective should be to construct a horizon-based framework to meet the relevant retirement planning objectives and to maintain a coherent asset allocation at total portfolio level. Allocation to deposits, gilts, corporate bonds, property and equities should reflect a person's retirement objectives, current and expected future tax status, and any relevant ethical views.
The client's term to retirement can be determined at the outset but must be monitored regularly to ensure that the asset allocation continues to reflect the level of risk the individual can tolerate and is prepared to take, as these may be quite different. One of the characteristics of modern pension planning is the uncertainty over the actual retirement date, and even where this is known, it may be different from the date when the client will purchase one or more annuities or move into drawdown. Flexible retirement is now firmly on the government's agenda and we can expect an increasing number of people to move from full-time work to part-time employment or self-employment in early retirement. For this period it may be better to draw on non-pension assets to boost earned income rather than to purchase annuities at a comparatively young age.
Economic studies show that asset allocation accounts for over 90% of the outcome for institutional pension funds, and the evidence applies as much to the individual investor.
This type of research can, however, be misinterpreted. Asset allocation will be a strong determinant in the outcome but it does not of itself guarantee a high return; rather it sets the return parameters providing an expected mean outcome for a given strategy. A risk-averse asset allocation might provide an expected annualised return of 2% above gilt yields, for example, where a more adventurous asset allocation would typically provide 3% over time.
Advisers have a wealth of risk profiling and asset allocation tools at their disposal to help assess a client's day-to-day comfort zone as well as longer-term financial plans, and to match these with an appropriate investment strategy. They can devise a simple questionnaire that does not assume an inherent understanding of asset class characteristics and this can help identify whether the client thinks of investment risk in terms of danger, uncertainty or opportunity. It also helps to determine whether risk is identified in terms of volatility, underperformance relative to the index or peer group, or the risk of not meeting long-term retirement objectives.
The profile results must be extrapolated to inform the investment strategy in light of a more complex and interrelated range of risks that include the following:
• a fall in the income derived from dividends or interest;
• interest rates, which will affect the price of bonds, for example, inflation risk, which will undermine real returns;
• default risk, where a borrower cannot meet interest payment or return the original capital - the principal;
• liquidity - the inability to find a seller;
• fiscal and political risk - for example a change in the taxation of investments or in the interrelation of private and state pensions;
• exchange rates, which can devalue an overseas investment; and
• economic risk - the impact of economic cycles.
There is also greater access to a much broader choice of asset classes than the traditional cash, gilt and equity classes used in earlier economic models. Fixed interest funds can meet specific investment objectives through the use of horizon-based gilt strategies, while bond funds can provide diversity through an appropriate combination of investment grade and sub-investment grade corporate bonds in the underlying portfolio. The growing number of property funds provides investors with access to commercial property and to the property development companies, while the range of alternative equity investments can add considerably to the potential for outperformance and or consistency of performance throughout the market cycles.
Private investors also have access to direct commercial property investment via a self-invested personal pension (Sipp) and, from April 2006, they will be able to hold residential property and a number of other assets in their pension funds. In theory they will be able to hold virtually any asset under the pension tax simplification rules, and an important part of an adviser's job may be to maintain clients focused on fundamental risk diversification strategies, and to warn against holding overseas holiday homes and the family yacht in a pension plan. These could knock the asset allocation off balance and incur high administration costs and prohibitively high taxes on private use.
Institutional investors such as pension funds use stochastic or Monte Carlo modelling to estimate the probability of certain events occurring, and to assess the impact on the portfolio and returns. Stochastic modelling simulates many different events that could impact on the investor and the portfolio. The result is a mean expected outcome and a statistical distribution of outcomes. It does not predict with total accuracy but it produces useful parameters for possible outcomes.
With this type of analysis at the adviser's disposal it becomes easier to create diversification across a broad range of asset classes and investment styles that helps to reduce risk and volatility at overall portfolio level, while maintaining the potential for outperformance. As access to different asset classes increases the private investor's asset allocation will become more complex. Investors need to aim for greater diversification, particularly in non-traditional asset classes, and to focus on sectors where the risk/reward ratio is genuinely attractive. For example, continental European and US equity markets tend to move in a similar direction to the UK stock market. But while these are important markets, they do not necessarily act as efficient diversifiers.
A more effective alternative would be to invest a modest amount in emerging markets and Japan, provided that the adviser or asset manager, for example a manager of managers, can identify specialist fund managers who really understand how these riskier capital markets work, and where the inefficiencies lie. Specialist managers need to take account of the structure of the local index, its concentration in specific companies, and any taxation barriers to active management, all of which help determine the available risk-return trade-offs.
Once the adviser has decided the proportion of investments to allocate to cash, gilts, bonds, property and equities - and to the different sub-sectors and styles within these asset classes - it is timely to consider how best to deploy active management fees. The academic papers stress the comparatively minor impact of active asset management in the overall return, which suggests that active management should be used sparingly and only where it can make a positive contribution after fees.
The cost of asset management is always relevant, especially in a period of prolonged low inflation and comparatively low returns. At such a time paying an annual management charge significantly in excess of 1% makes little sense if one can achieve the same result for the efficient markets, after fees, with an index tracker.
The costs and benefits of multimanager/fund-of-funds offerings should be similarly assessed. Where appropriate, they can provide clients with active reviews as a built-in feature - at least for the portfolio.
David Marlow, marketing director, Alexander Forbes Financial Services
Allocation to deposits, gilts, corporate bonds, property and equities should reflect retirement objectives, current and expected future tax status, and relevant ethical views.
Asset allocation is a strong determinant but does not guarantee a high return: rather it sets return parameters providing an expected mean outcome for a given strategy.
When the proportion of investments allocated to cash, gilts, bonds, property and equities has been decided, one should consider how best to deploy active management fees as sometimes the same result can be achieved with an index tracker.