Asset allocation in stormy times

Today\'s volatile markets ram home the fact that defined contribution pensions pass all risk on to employees, making the issue of asset allocation crucial, John Greenwood reports

Pensions advisers have been taking a sanguine approach to the biggest fall in the FTSE for over six years. The 5.5 per cent fall on January 21 following stark warnings about recession in the US was just the sort of rocky start to the year that many analysts had flagged up in the last months of 20007.

While the newspapers are full of gloom, providers and advisers are repeating the ‘don’t panic’ mantra. While anyone uttering those words runs the risk of sounding like Corporal Jones, now is certainly a time for a measured communication strategy, at least to those workforces that expect to receive regular updates from their scheme advisers.

A letter out of the blue warning of the consequences of falling markets could create an adverse reaction to pension scheme members who never hear anything other than their annual statement, says Andy Cheseldine, a consultant at Hewitt, but there are situations where now is a good time to talk to employees.

“Without wanting to panic them, it can be worth reminding members of the long term nature of pension investments and the fact that they have the benefit of pound cost averaging. But also it is worth saying that we have been here before,” says Cheseldine. “Do we regard this as absolutely extreme market behaviour or is this simply what we all know equities do?”

The January 21 fall is certainly nowhere near the fall on Black Monday back in October 1987 when stocks fell 20 per cent in two days. The list of other crises is well known – the pound’s 1992 struggle to remain in the ERM that saw the Norman Lamont increase interest rates to 15 per cent, the Russian crisis of 1998, the long collapse of the dotcom bubble which was helped on by the 5.7 per cent FTSE fall following the Twin Towers attacks.

Yet as we all know, the message from corporate advisers looking to demonstrate a steady hand at the tiller and calm employers and staff is to remind them that those who have invested through the ups and downs of the last 20 years will have seen their money grow significantly.

That is not to say there are specific segments of the workforce who may need particular care now. Most vulnerable to the recent market nosedive are those employees within five years of retirement. Experts recommend that January’s market turbulence should prompt advisers to engage in a communication exercise with older members of defined contract pension scheme members to ensure their investments are in the right asset classes.

Writing to all members of staff encouraging them to make sure the retirement date stated on their pension documentation is realistic is one way to reduce the risk that employees will lose out. For scheme members in balanced managed or equity funds who are planning to retire soon, the recent volatility could be a serious threat to their retirement, particularly if they have given a retirement date of 65 but are planning to retire before then.

Simon Pearse, an investment consultant at Mercer, says market conditions mean it is time to talk to scheme members about their investments.” Without a benefit guarantee from their employer, members of DC schemes bear the risks of any downturn in investment performance, and so a market fall is more evident in terms of reduced fund levels.

“If members have not reviewed their investment options recently then this is a timely reminder to do so. They need to know that they can cope with further falls if these were to happen, particularly if they are approaching retirement. This could mean moving to asset classes with more stable returns but with a lower potential for high growth. In the longer term this may mean paying a higher regular contribution into their fund to compensate.”

The continued growth of defined contribution pensions will see new ways to protect capital in those vital years before retirement when fund sizes are at their largest.

Standard Life is one provider looking at alternatives to lifestyling to allow pension savers to insure themselves against market turbulence in the final years of their retirement. John Lawson, head of pension development at Standard says the company is looking at ways to offer retail investors simple hedging structures to protect against market falls. “It could be a case of guranteeing to preserve capital and then taking 80 per cent of any upside going forward. I anticipate we and other insurers will develop models like this in the next couple of years,” he says.

But until these arrangements are widely available, and given that most scheme members will not have the benefit of individual advice, making sure asset allocation strategies match members’ requirements will be increasingly important. Rocky markets ram home the fact that defined contribution pensions pass risk entirely on to employees. If we are to avoid horror stories about volatility crippling pensioners then asset allocation is paramount.