How personal is the asset allocation decision in a defined contribution scheme?
“You know how, in manufacturing days, companies used to make widgets? Well, we make virtual widgets, that’s the best way I can explain it,” said Audrey to her neighbour. “And after a year, we’re doing well enough that our boss is introducing a pension scheme. He’s going to put 8% of our pay into a fund every year, and wants to know how we want it invested. Well, what do I know about investing? I don’t know what to tell him! And what with the divorce and starting again, at my age, with no savings,…”
A wetness on her cheek, then the stiff upper lip asserted itself. “I’m going to tell him he should decide for all of us. I just don’t know. I can’t afford to take a risk with the pension scheme. I don’t even know if I’ll ever be able to afford to retire. Maybe I should set some more money aside ….”
As it turned out when the employees met the following week, they had all been thinking about the investment question, and ignorance was their honest common factor. All but Bob, that is. He knew his mind.
“Look, I too have no savings. In a way, you and I are both at a new stage in life, Audrey. But I have no commitments, and I’m lucky enough for time to be my friend. My parents told me that this pension scheme can make a big difference in my life, because even with my small wage, my small investments will compound into something very big. They said that I should go for the best possible return, because even if the market goes down, I’ve got the time to wait for it to recover. And they said it’s bound to recover – certainly within their lifetime, let alone mine,” he said.
“At 25, you’re young enough for a naïve, innocent conviction about what you want,” replied Charles. “I can’t take a roller-coaster ride. I’ll sacrifice the high return you’re looking for if I could be sure of something steadier. I’m happy to find myself suddenly adding 8% to my savings every year. If someone can help me keep all my savings ahead of inflation, that’s good enough for me. I understand why people who lived through the Depression were scarred by it for life. I started working in the late 70s, and I’m scarred by the fear of inflation. Protect me from it, that’s all I ask.”
Dorothy and Eddie, like Charles, were middle-aged. Dorothy was mathematically inclined, and was the company’s amateur expert on investing. “As you know, I have something put away, but not nearly enough to retire on. Of course, I don’t think of retirement – I like to call it my next career, when I’ll want to keep my mind active and work part-time, but spend more time on my hobbies. I discussed it with my financial planner” – revelation! Dorothy had a financial planner! – “and he said my husband and I should now start a new account for large purchases and emergencies, and use the pension scheme to supplement our retirement savings. So I’m somewhere in the middle”
Eddie was more of a gambler. “I don’t understand this stuff really well, but I remember reading an article” – it seemed they all looked at the financial pages, in contrast to the previous generation – “that said it’s best to let investment returns pay for your retirement.”
“What on earth does that mean?” challenged Audrey.
“It said that, over a lifetime, investment returns will eventually account for eighty to ninety pence out of every pound of your savings nest-egg. That’s the power of compound interest. Eventually your investment returns become many times bigger than the savings you put into the scheme,” Eddie replied.
“Einstein said that compound interest is the most powerful force in the universe,” interjected Fred, who until then had been content to listen to the others. He was the boss. It pleased him that his employees were collegial enough to have this open discussion, though he feared it was all too vague at this stage to constitute investment intent. But he wanted to encourage them to realise that compound interest and time were such powerful factors. His brother had married an actuary, and his sister-in-law was full of pithy financial wisdom that Fred had picked up.
“And so,” Eddie continued, “I want to go for a really high return. I want to let the return pay for my retirement.”
“But if you go for a high return, it’s like betting,” objected Dorothy.
“We’re all betting, in a way,” Eddie replied. “There’s no certainty.”
“But if you go for broke and lose?”
“Then I lose. That’s my nature. But I won’t lose. I won’t go for broke. I’m not that greedy. But you and I are different people, Dorothy. You love stability and calculation. You go for the middle of the road. I travel nearer the edge. It won’t be smooth, but I can take the rough with the smooth. And even at 50, I think I have the time to bet that there’ll be more smooth than rough. I won’t sleep as well as you, and I might not ultimately do as well as you, but I want to give the markets a chance to help me.”
“Well, whatever you choose,” said Dorothy. “I guess it isn’t right or wrong. It’s just what you’re comfortable living with.”
That was the gist of the discussion. It continued, but nobody had any greater insights to offer. While they could enunciate their situations and their attitudes, Fred hadn’t got from the conversation any notion that he could comfortably let them make their own investment decisions. He felt responsible.
He was disappointed. He knew they were individualists, and talented at their jobs. But they didn’t know enough about investments. They knew something – that was the tantalising thing! But not enough.
What would you do, if you were a trustee of a scheme with these participants? Would you make a single decision for all participants? Would you go further and leave that decision to the scheme’s investment manager? Would you assign employees to one of perhaps three asset allocation policies, focusing more on a high return for younger employees and more on risk control for older employees? Would you offer employees a choice of the three, and tell them that if they place the choice back in your hands, you will assign them to one of the three allocations based on their age? Would you give them even greater freedom and permit them to select individual investments, not just an asset allocation?
Fred didn’t want to go for a one-size-fits-all investment plan. Clearly his employees were individuals. Dorothy had the advantage of working with a financial planner. Fred couldn’t offer them all that benefit, but he called in a consultant. He liked the consultant’s approach, split into two parts. The first dealt with the personal situation, the second with attitude to risk.
Personal situations vary, not just by age. For example, many investors are beginners. Some, like Bob, are starting out; others, like Audrey, are starting over. Most are midway through a savings programme, like Charles, Dorothy and Eddie. Some are almost retired, though Fred didn’t have that type in his young company. Beginners tend to invest 60% to 100% in equities, the rest in fixed interest. Those midway tend to invest 40% to 80% in equities. Those nearing retirement tend to invest 20% to 60% in equities. So age does make a difference.
But within those broad bands, attitude to risk makes a difference too. The consultant had a list of about 10 questions that extracted that attitude from each participant. And in the absence of a fully-fledged financial planner, the questionnaire helped each participant to find a comfortable asset allocation. Nobody wanted to pick individual securities, thank goodness, reflected Fred. Leave that issue for another year.
Clearly there was a need for an ongoing education programme. But this was as much as he could do for the moment.
What do you think, reader? Of the workers, their attitudes, Fred’s decision, the consultant’s approach?
Don Ezra is director of strategic advice at Frank Russell Company