The past two years have set new standards is market volatility! The gyrations in key market indices have led to periods of extreme optimism and fear among investors. It seems that when the common investor is long when there is a sell-off; and when people sell, markets tend to bounce back! Short term volatility affects the mood for long term investments.
So what does this mean for Pension Investments?
Before we talk about the impact of market volatility on Pensions, however, let’s take a recap on why early investment towards a Pension Fund is important. The fact is that the earlier one starts to save for Pensions the better it is. The magic of compounding takes effect i.e. the income generated each year on previous years saving and the income earned on that. This compounding of income creates wealth.
As an example, a 25 year old, retiring at age 60, will need to invest Rs 23,166 per annum for a desired pension accumulated “corpus” of Rs. 1 crore, if regular investments are made earning an average of 12% per annum. However, if pension accumulation is delayed to age 40, the required annual investment would increase to Rs. 138,788.
One could argue that extraordinary gains can be made on large accumulated pension amounts if the investor could time the market and work towards an ideal time to cash out. The fact is that it is extremely difficult to time the market and even professional fund managers are not able to make large profits compared to the benchmark index. It is recommended that one keep the following simple examples and rules of thumb in mind in planning their Pension investments.
Pension investments and asset allocation should factor the time period for the investment as well as life stage. This is because market volatility has a different impact, on investments based on tenure, and life stage on risk appetite. The fact is that needs and risk profiles change over time; and therefore asset allocation (or how much to invest in which type of investment) should change with life stage and risk profile (rebalancing the portfolio). (Link to US Securities Commission: Asset Allocation 101: http://www.sec.gov/investor/pubs/assetallocation.htm)
For example, a regular investment with a residual period of 1-3 years is likely to be effected very differently under extreme market volatility, say if the market falls 20%; compared to a regular investment with a residual period of 10 years. A person approaching retirement can see their Pension Asset depleted significantly if their investments are in an Equity Fund and the market falls by 20%. The longer term investment, on the other hand, will have both longer to recover from the market sell-off; as well as benefit from additional investments at lower prices.
Similarly, a person approaching retirement would have a lower risk profile, given the upcoming need to draw on the pension; compared to a person aged 25 who can keep investing regularly and therefore need not be impacted by volatility, and can use market volatility to their benefit by averaging the cost of regular investments.
It is important that both these factors be considered and investments made appropriately in a Pension Fund.
Despite the market volatility of recent times, longer term, regular, investment in Equities returns higher returns compared to investment in fixed income securities.
For any lump sum investment targeted at an Equity linked Pension Fund, in times of extreme volatility, one could invest 30-40% in a single lump sum; with the balance invested in a Debt oriented fund with systematic transfers into the Equity Fund – thereby providing averaging of prices during the investment period.
The general rule of thumb for allocation to equities that may be considered is:
100 (-) Age (%)
i.e. for a Person Age 30; allocation to equities can be 70% of value of investments, including bank & fixed deposits, PPF, EPF, etc.
Higher allocation to Equity linked Pension Funds during an age of 20-50 for a Pension maturing at age 60 can help accumulate a larger Pension, working on the belief that the Indian economy is on secular strong growth path and consequently corporate earnings and stock prices should gain over the medium to long term, short term market volatility notwithstanding.
Links: Asset Allocation 101. http://www.sec.gov/investor/pubs/assetallocation.htm