Hope all is well?! Last week we shared some ideas on the best way to accumulate €1m, and whether a deposit regular savings account or a pension route might be the most effective way of doing it. We analysed these two routes and factored in deposit rates, pension fund returns, fees and charges and various tax rates that apply to both and how they will impact on the end result. As always, it pays to begin with the end in mind! This week I hope to share ideas on how to select a suitable investment fund, how to avoid common mistakes, and how to deal with the consequences of funds not performing as you may have hoped.
If you have read or listened to last weeks' episode you will recall that based on realistic assumptions that the pension route would stand to be in the region of €400,000 more effective than a deposit account! A large portion of this net euro benefit was as a result of the tax reliefs (currently) available to 'Sam' on the contributions made to a pension. The remainder of the net euro benefit came from the average annual return that the pension delivered to 'Sam'. I received a lot of emails from individuals on that last episode, some expressing surprise and some seeking further information. One of the questions that was put to me was, 'Well what if the fund I am in does not deliver the 6% return, or indeed if it is negative returns for a long period of time'. In my experience at least this is a very real concern that many have, and feel quite uncertain about it, so lets explore.
Almost 18 months ago I shared some views on the impact of time on our investments, and the fact that, in the S&P 500 at least, there has yet to be a single 20 year rolling period which delivered negative returns for investors. But we all know that what has happened in the past may or may not happen in the future. Personally I am a stoic when it comes to the constant upward curve of a well diversified portfolio of quality equities, and that irrespective of what is happening, and has always been happening at a particular point in time in global economies, that global progress, consumption and demand drives the productivity, profit and performance of the best of companies who provide these products and services. We cannot know that this will be the case, no more than we can know that the sun will definitely rise tomorrow!
So having said all that lets assume that you invest your pension contributions in such a global equity portfolio in order to benefit from the anticipated and expected long term growth of global equities. The average long term annual returns from a basic index of this type has been in and around 10% per year, and indeed in the past 5 years a well chosen index of this type has delivered over 60% growth, but despite all that we're going to assume that the fund delivers less than the 6% we assumed in the calculations last week.
How To Avoid Common Fund-Selection Mistakes:
What impact might lesser returns have on my final pot-size? Well this is a question that many people ask, and I would suggest that the question itself is irrelevant to a degree. If you are planning to build a sizable pension pot or nest egg for yourself to retire on then you'll ideally need a clear plan with which to achieve it, based on your own and/or your advisors assumptions and input.
If we were 'Sam' from last week our 'plan' would be to religiously and unwaveringly contribute €2337 each and every month to the selected fund. When that same fund falls 20, 30, 40% in value we keep contributing, when it rises in value to 20, 30, 40% we keep contributing, we contribute based on the fact that history has advised that is the only viable option to do when our aim is to benefit from the constant upward curve of global equity growth. We do this for 23 years and we stand a high likelihood of achieving our plan of reaching €1m, or better. If we waver off that plan, if we stop contributing when markets have a temporary decline, if we reduce our monthly contribution, if we think we have a better idea (such as investing in bitcoin when everyone was telling you to!), those are the times when you throw your plan out the window and sacrifice the end goal.
If we assume that you stick to the plan, and that through no fault of our own (it usually is our fault!) the pot does not grow at the rate we had expected, there are a few reasons why it may not have:
- You may have selected an actively manged fund that was performing for a period due to effective management/luck, but then performance dipped due to a change in manager/luck
- You may have been paying very high fees which eroded your fund growth despite the fund performing well. We have seen cases where investors were paying almost 3% per year in fund fees, and 5% of every contribution (which amounts to in the region of €32,000 fees per year as you near retirement!)
- The fund you have selected or been advised to invest in is a 'low volatility fund' which carries a large portion of Bonds or Cash which will be unlikely to deliver anything more than 2-3% per year in returns, before fees)
- Markets could potentially go on a 23 year run of poor or negative performance, and even if you are invested in the right fund, at the right price and in the right way, it may still not deliver.
If you have managed to avoid items 1-3 then you are in reasonably good shape as an investor! Nobody can control item 4, nobody can predict it and nobody can influence it, the markets will do what they do (which up to now has been indefatigably ascend over the long term!).
The Impact Of Poor Fund Performance:
Last week we arrived at a strategy of contributing €2337 per month for 23 years, achieve 6% growth average per year (or 4.2% as we suggested after the 1.8% pension fund fee), and arrive at a final pot value at 68 of €1m. All very straight-forward and clear. However how will the final pot value differ if the return does not hit the 4.2% Net average return.
If you stuck to the plan but your fund deliver (due to any of points 1 to 4 above) an average of 2.2% per year then your final pot value at 68 would be €837,000, which is €170,000 shy of what it would be if you achieve 2% average return more per year
If your fund delivered only 1.2% per year then your final pot value at 68 would be €740,000, or €260,000 short of where you wanted it to be.
If, for some super-naturally awful reason the fund delivered negative average growth of say -1.2%, you would finish with a pot value of €560,000 at 68, or around half of what it would have been had you achieved the target 4.2% return. Nobody would be satisfied with that outcome.
If, on the flip side your fund average 5.2% (remember all these examples are assuming a 1.8% all-in pension fund fee) you would have a final pot value of over €1.2m, or if you achieved the long term return of 9.2% you have a cool €2m at age 68, which also happens to be the Standard Fund Threshold level, over which you will pay significant tax penalties, so best to keep to the €2m if you can at all!
My Options If Returns Are Below Expectation:
In our scenario it was a 23 year journey that 'Sam' was embarking on, and lets say if at year 15 considers that the outcomes do not look good for the final pot value, it really may be too early to make any wholesale changes. Once Sam can verify that the fund is of a solid nature, that the fees are of a fair nature, and that the advice is right, there really is little or no reason to change funds or advice source.
We cannot control the markets, we must remain optimistic about the outcomes here, even if they have been under-performing for several years, this is normal and to be expected, we cannot control the markets, I repeat!
So, what can we control? Well in the words of Viktor Frankl; 'Between stimulus and response, there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom'. If you have not read it then I can't recommend Viktor's book, 'Man's Search For Meaning' enough. In that small yet truly inspiring book he shares his story and paints for us all a picture to accept responsibility for our decisions, and our responses to events external to us. Mammoth.
So, in that vain, what can WE do if we find ourselves a couple of years from retirement and the pot is not what we had hoped? Well it is very simple really:
a) Invest more now for the remaining years
b) Wait for markets to climb and our fund value to improve before taking our 25% tax free lump sum
c) Postpone our retirement for number of years allowing us to contribute more, and for value to improve
d) Retire as planned and accept a smaller tax free lump sum, and lower level of income than we had planned-for
I would love to offer some sexier and commercially appealing options but I am a practical and truth-telling individual, these are the only options available to you in those circumstances. If you had made the right plan at the outset and had avoided the common mistakes outlined earlier then you had done all that you could possibly have done to give yourself the very best chance of a superb outcome. If timing, or some global apocalypse unlike anything that the modern world has seen in the past 200 years were to befall us and scupper your plans then all we can do, in the words of Viktor Frankl, is to accept responsibility for our response, and to go and do it.
A seemingly insignificant difference in the average return over the sort of period of time in the above scenarios, and that sort of contribution-level can clearly have a really significant impact on the final value of a pension pot, and so for that reason I implore everyone and anyone that is doing this sort of funding to make sure that they check their fees (as best they can - it's often shrouded in mystery!), check that they are in funds that stand a chance of delivering them the returns they need, and that they have a plan which they will and can stick to no matter what happens in the years ahead!
Thanks For Reading,
Paddy Delaney QFA RPA APA