Cash Clinic - Personal Pension

13th October 2011

The Scottish Private Client & Financial Services team answer your queries.

Q. I am 40 of age and make regular contributions to a personal pension. Alongside my personal pension, I also contribute to a group employer pension. I would like to retire age 60 but with the recent stockmarket volatility I am concerned that my fund will provide a large enough income for me to retire on. Should I be concerned with the current levels of volatility and are there any ways in which I could help safeguard my fund value?

A. With continuing uncertainty over the state of the global economy, many investors have noticed that their pension funds and other invested assets are falling and rising in value much quicker than before. The questions posed are, what is investment volatility, how does it affect me and should I be worried.

Volatility is a measure ofhow much the prices of a particular stock or fund fluctuate over a given period time. Ordinarily, this is measured over a one-year period and compared to the comparative movement of a relevant benchmark.

Where the price of a fund fluctuates significantly over the period and especially over the short-term, the fund is deemed to have a high degree of volatility. Conversely, where the fund price remains largely constant, it is assigned a low volatility.

The main aim of planning for retirement is to ensure that a pension is not only sufficiently funded, but that the underlying asset allocation has the potential of producing the best risk-adjusted rate of return.

Pension planning is generally classed as a long-term investment strategy and as such is less affected by volatility. The longer the investment period, the effect of volatility is smoothed outas prices are able to recover over time. It has to be borne in mind that the movement of a fund will only cause concern when at the age of retirement the fund value is significantly below the expected level based on the regular contribution level or it is below the average value of the fund.

Where the underlying investment has a high degree of volatility attaching to it, the real risk arises when people near their nominated retirement age and prices drop sharply leaving their fund with little or no time to recover. The end result is that the level of income they are able to purchase in exchange for their pension savings can at times be significantly reduced.

One attempt to reduce volatility is to devise an investment strategy where the underlying asset allocation is sufficiently diversified to ensure the allocated assets and geographical regions are not correlated in their movement up or down.

The longer the fund is invested there may even be an argument that an individual making regular contributions to a pension, will benefit from the pound-cost averaging. This concept assumes that in times where the fund is negatively affected by volatility, the benefit to pension investors is that the same contribution will buy more units in the underlying investment. This in turn will ensure that in the recovery phase the extra units will ensure additional growth.

‘Lifestyling’ may be another way of addressing the volatility of a pension fund by balancing the downside protection and risk. Lifestyling funds offer a safeguarded, pre-determined investment selection where the underlying investment reduces in risk as the individual approaches their retirement date. The risk is reduced by way of automated switches at pre-selected dates from the higher risk, more volatile (mainly equities) to lower risk, less volatile (fixed interest or cash) investments.

The downside of lifestyling is that the fund performance will never be in a position to provide the best possible return for contributions made, but instead can at best achieve a reasonable growth with a balance or safety versus risk.

For people with investment terms of 10 years or more, this, unfortunately is unlikely to be the last economic crisis that they will encounter. Taking steps like selecting a lifestyling option and having a properly diversified investment strategy can help deal with volatility, especially as one approaches retirement age and can arguably bear it least.