Please sir, I want some more…..

In Charles Dickins’ famous novel Oliver Twist, spoon in hand, Oliver asks the master of the workhouse for another bowl of gruel. He, along with all his comrades at the workhouse, were hungry. At the point of starvation they decided they could take no more. Something had to be done….

Oliver had drawn the short straw and was tasked with asking the master for more food. He was about to do something which hadn’t been done before, there was a risk it wouldn’t end well. Unfortunately that day things didn’t play out as hoped and he got a beating for his troubles. However, Oliver was a determined young boy and this was to be the start of a journey which saw him lift himself out of his unfortunate start in life.

The point of the story is that often in life if we want to change things or achieve something we have to take an element of risk to make it happen. In the previous blog post we talked about investment returns and the benefits of compound interest. This blog post will provide a high level run through of how investment markets work and where your pension contributions are actually invested.

Whilst we’ve only so far talked about risk. When thinking about what this means for investing, similar to life, there’s clearly a trade off:

If we take more risk we expect to be compensated approptately and generate a higher investment return over the long-term.

We’ll now explain the main asset classes your pension investments are likely to be invested in. Beginning with those asset classes which have the lowest risk and associated investment return and moving through the spectrum to those with the highest risk and expected return.

1. Bank Account/Cash Fund – One option is to invest your money in a bank account or cash fund. This is great if you are very prudent and don’t want your investments to lose money (or you expect to need to access the money in the short-term). The problem with investing your money in a bank account is that in the UK the Bank of England base rate is currently 0.75%. If you were to earn that investment return it would take you around 95 years to double your money! The one benefit of investing your money in a bank account (or cash fund) is that if short-term interest rates increase then the rate of interest you earn also increases too.
2. Government Bonds (often called government debt) – Many people take out mortgages to spread out the cost of a house purchase over a long time period (typically 15–30 years). In a similar vein, governments also borrow money over long time periods to pay for expensive items (which includes building hospitals, bridges and motorways). Using future tax revenues to then meet the repayments. The big difference between investing in government bonds and a bank account is that the yield (which is similar to the interest rate you’re paid each year) is set at outset for the whole term. When a government issues a bond they agree to pay you regular interest payments (often annually or semi annually) and then return your initial investment at the end of the agreed term. In return for agreeing to invest over a long time period the government has to pay you more to incentivise you to invest in their bonds over holding your money in a bank account (where the investment return isn’t fixed and could increase in future if the Bank of England increases short-term interest rates). At the time of writing this article the 30 year UK government bond yield is 1.35%. A meaningful increase on the 0.75% you’d get each year relative to investing your pension contributions in the bank but you would also be locking in the return you expect to receive today for the next 30 years! Assuming you held the bond for the full 30 year term your return would be 1.35% per year (meaning your investment would increase in value by around 50% over the 30 years). Now the UK government is expected to meet all it’s borrowing obligations (if it needs to it can just raises taxes to pay its debts) so in a way the 1.35% yield over the full life of the bond represents what people think short-term interest rates will be over the full 30 year period. the 1.35% yield for the 30 years accounts for the current short-term rate of 0.75% today and also allows for people expecting the short-term rate to progressively increase over time such that the average over the full 30 years is 1.35%. (For the record, the Bank of England base rate has been at record lows between 0.5% and 0.75% for the last decade. Needless to say, we live in extraordinary times).

***Caveat Emptor (Buyer beware)***

Now government bonds are traded daily and there’s around £1.8 trillion currently outstanding. (yes you read that right, 1.8 million million). Like houses and petrol prices their value can (and does) go up and down. Whilst one never expects their bank account to go down in value, government bonds can fall in value if people expect interest rates in the UK to increase in future by more than what’s already priced in.

Why is that? Well you’ve locked into your investment return when you would have been better off holding your money in the bank, where you’d have earned more in interest as short-term interest rates are increased by more than previously expected in the years ahead).

In terms of the risk and return trade off mentioned earlier, by investing in government bonds you expect to receive a higher return over the long-term but there’s no free lunch. There’s a risk that the value of your investment could fall between the period when you invest and when the last payment is made to you and there’s also the risk that you could have generated a higher return by holding the money in the bank. (There’s also the risk that the issuer (i.e. the government could not make the payments promised but in the UK and the rest of the developed world the likelihood of that happening is assumed to be pretty low).

3. Corporate Bonds (also called corporate debt) – Similar to governments, large companies in developed markets (i.e. the UK, USA, Europe etc.) with reliable income streams (think of Microsoft, BP, Unilever etc.) issue bonds to help them finance their large projects (new pipelines, building new factories, product development etc.). Corporate bonds are issued by highly regarded companies and as a result they meet the criteria to be deemed ‘investment grade’.

Corporate bonds aren’t as secure as government bonds because they aren’t backed by a government. Companies can’t raise taxes. They can raise prices or increase production but there’s no guarantee that people will buy their product/products.

As a result, companies have to pay investors more (I.e. give you a higher investment return or yield) in return for you taking additional risk and investing your money with them. Roughly speaking, the additional yield is around 2% p.a. above the yield on a government bond of a similar term.

It’s also worth noting that most corporate bonds are issued with terms of between 5 and 15 years (consumer habits change over time and whilst we’re pretty sure the UK government will still be around in 30–50 years there’s much less certainty that any one particular company will still be trading a long way into the future (think Kodak, BlockBuster and Lehman Brothers which all no longer exist).

***Spreading your risks***

Now pension scheme investments are prudently managed. if you invest in a corporate bond fund you won’t be investing in just one or two corporate bonds. You’ll be investing in a large number of corporate bonds (issued by between 50 and 500 (or possibly more) different companies). Your investment will be spread across a wide range of companies which dramatically reduces the risks which you are exposed to. Also, in terms of investor protection, investing in investment grade corporate bonds means you are typically either at the top or towards the top of the pecking order. When the company is running business as usual it has a legal obligation to honour the payments it’s promised you if it wants to keep trading.

And what if they don’t pay you? They are forced to file for bankruptcy and can no longer trading.

And if they do file for bankruptcy? The company is wound up and you’re top of the pile when any assets they have are sold and the cash is handed back to investors.

During times of economic uncertainty companies are expected to generate lower revenue. However, given companies have to meet their bond obligations or face insolvency they will typically do everything within their power to meet these obligations, including halting any payments due to equity holders (see below).

4. Equity (also known as stocks or shares )– This is the riskiest type of publically traded investment to hold (publicly traded just means they can be bought and sold easily). You own a share of the company profits (i.e. you can consider yourself a part owner of the business) and you will receive a share of the company’s profits once everyone else has taken what’s due to them (the payments you receive are usually paid annually or half yearly and are called dividends).

Over the long-term equities are expected to provide the highest return but they’re also the highest risk asset class to invest in. Similar to investing in corporate bonds, typically pension scheme investments will invest in well diversified funds holding the equity of at least 50 and typically significantly more underlying companies. By investing in equity funds you become a part owner of some of the largest and most profitable companies in the world (think Apple, Adidas, Mercedes Benz etc.).

The maths behind what you receive as an equity investor is fairly simple.

Annual company revenue – costs incurred = annual profit.

As a shareholder you can expect to receive your share of the company profits once the company has paid their costs.

So what’s the expected return for holding equity investments? Well similar to corporate bonds, the equity we’re referring to here is the equity of companies operating in developed markets. Typically speaking, investors can expect to receive around 2–3% more each year for investing in these equity markets compared with investing in developed market corporate bonds. The biggest risk is that in the event of an economic downturn (think back to 2008) equity investments are the lightening rod through which the most pain is felt (peak to trough equities fell in value by around 40% during 2008).

What casues an invesmtent to fall in value by 40%? If the global (or indeed any) economy contracts, people and businesses start spending less (if we all think the outlook looks bleaker and we might lose our jobs we reduce our spending and save more). However, companies still have to pay what they’ve contractually agreed to (i.e. they have to pay salaries, rents and the debt repayments they’ve already promised to corporate bond holders). That means that whilst revenue shrinks they still have to pay their fixed costs – which, as the name suggests – remain broadly static. Back to the equation shown above, when revenue is reducing the scales only balance with a corresponding reduction in profit. In cases where costs are high a reduction in revenue can result in a meaningful reduction in profit. If company profits are expected to be lower going forward then holding equity investments (which are priced by putting a value on what the future expected profits of said company) will fall, sometimes radically.

In return for accepting this higher level of risk, over the long run we expect equities to provide us with higher returns (why else would we take the risks associated with investing in this asset class?). That’s not to say that over the short-term there’s anything to stop an investor buying into the equity market (when valuations may or may not be at their peak) before there’s a subsequent correction shortly afterwards which could take a few years (or longer) before their investment recovers its value.

By way of an example, if you’d invested in the FTSE 100 in November 2007 you wouldn’t have known that your investment was about to fall by 30% over the next 12 months. It would have taken you over 2 and a half years for your investment to recover its value). Thankfully if you’d have stayed invested you’d now be up around 80% from when you initially invested. A great investment return for just over 10 years but this example demonstrates just how risks can manifest themselves in pension (or indeed any) investment portfolio. Also, you might have found the journey too intolerable to bear. Once your investment had lost a quarter of its value you might have after decided to sell your equity investment and move the proceeds into cash. Doing that would have locked in a 25% loss with no chance to benefit from the subsequent recovery.

The good thing with being a long-term investor is something called pound cost averaging. Investing monthly means you can “average in” to equity (or indeed any) investment. When equity markets fall in value you get to buy more at a cheaper price – think of clothes being on sale. Over the long-term this means you are able to “average in” your purchase price.

5. Are there other asset classes to invest in? The short answer is yes. Commonly emerging market equity (that’s the equity of companies listed in emerging markets – think Samsung and Alibaba) and debt (that’s the debt issued by the governments of emerging market countries – think India and Brazil) are held within pension scheme investment portfolios. You might also be able to invest in property funds or even funds which have an ethical tilt. There’s also high yield bonds (which are similar to corporate bonds but it’s debt issued by companies which don’t meet the criteria to be categorised as ‘investment grade’. As a result they’re referred to as ‘sub investment grade’ which is a technical term to show the debt has been issued by companies which are deemed to be in a weaker financial position than those which meet the criteria classified to be considered ‘investment grade’).

Linking back to the title of this article, Please sir, can I have some more? In an investment context there’s a wide range of potential investment returns on offer. Clearly the higher investment return you’re able to generate the better but prior to investing in any asset class you should be aware of the risks associated with investing in said asset class.

The majority of pension scheme investors will be invested in their provider’s default fund (this is the fund chosen for those people who don’t wish (or feel best placed) to make decisions around where their pension investments are invested. This means professionals will decide which asset class (or combination of asset classes) to invest your pension fund in. Striking a careful balance between the expected return and expected level of risk to take on your behalf. If you decide to invest in self-select funds (i.e. funds where you decide where they are invested) the Pensions Penguin suggests you consider contacting a qualified professional.

If you found this article interesting of if you have any views or comments please get in touch with us.