Why choosing the right Investment Strategy is key to maximizing the potential of your Private Pension Pot

Maximizing Your Pension Plan Investment Potential: Choosing the Right Strategy for Optimal Returns

The Strong Case of how and why Unit Linked Strategies outperform Capital Guaranteed Strategies over the Long-Term

Planning for retirement requires careful consideration of various factors, and one crucial aspect is making the most of your pension plan investment. With numerous options available, it's essential to choose a strategy that aligns with your long-term financial goals. In this Newsletter, we will explore the benefits of unit-linked strategies that invest in a mix of equities and bonds, highlighting their repeated superior past ?performance over "with profits" capital guaranteed strategies. We will also delve into the power of drip investing, compounding and diversification over the long term, while emphasizing why such approach is an effective and proven way to contain risk.

Unit-Linked Strategies vs. "With Profits" Capital Guaranteed Policies:

When it comes to investing money put aside into your pension plan, unit-linked strategies have proven to be more profitable over the long term compared to "with profits" capital guaranteed policies. Unit-linked strategies offer greater flexibility by investing in a mix of equities and bonds according to one’s risk profile. Equities provide the potential for higher returns, albeit with increased volatility, while bonds offer stability and income generation. It is within the nature of the markets that the greater the exposure towards equities, the higher the volatility but the higher the return over the longer-term.

Such unit linked strategies invest across various asset classes (mainly corporate bonds, government bonds, equities and cash), across various geographical regions and different sectors and thus benefit from the concept of full diversification. This means that the risk is spread considerably thus reducing the impact of any single investment's performance on the overall portfolio as well as any geographical risk and sector constraints.

In contrast, "with profits" capital guaranteed policies often provide limited exposure to equities and have relatively lower returns due to their focus on capital preservation. Such strategy offers policyholders the benefit of both capital protection and potential participation in the profits of the underlying with profits fund. The insurance company guarantees the return of the initial capital investment, ensuring that the policyholder's principal amount is secure. Additionally, the policyholder may be entitled to receive bonuses or dividends based on the investment performance.

While the combination of capital protection and potential for additional profits makes the capital guaranteed "with profits" policy seem an attractive option for individuals seeking a balance between security and potential growth in their pension pot, the opportunity cost of choosing such a strategy for an investment which is long-term in nature is significant as we will see later.

To make the argument stronger, I will first discuss some distinct characteristics of a Pension Plan Investment: Compounding returns and Risk containment through Drip investing over the long-term. I will also delve into factual historical returns over a long period of time which will lead to the bottom line of the argument.

The Power of Compounding:

Compounding is a powerful wealth-building characteristic of a pension plan investment, and this particularly refers to the continual reinvestment of investment earnings. As your investments generate returns, these gains are reinvested, leading to exponential growth over time. The longer your investment horizon, the more powerful compounding becomes. By starting early and staying committed, you can harness the compounding effect to significantly enhance your pension plan's value.

However, this becomes more apparent when average annual returns are higher. Choosing what is perceived as a safer strategy, however, comes at a significant cost especially when considering the whole picture. We will see this later on in the below calculation.

Risk Containment through Drip investing, Diversification and taking a Long-Term Approach:

Another powerful wealth-building concept is drip investing. This typically involves consistently investing a fixed amount into your pension plan at regular intervals, regardless of market conditions. This approach which is also known as euro-cost averaging, allows you to purchase more units when prices are low and fewer units when prices are high.

Diversification is a crucial risk management strategy. By investing in a mix of equities and bonds through unit-linked strategies, you spread risk across different asset classes, sectors and geographical regions. When one investment underperforms, others may compensate, helping to mitigate potential losses.

A long-term approach is vital when investing in your pension plan. Short-term market fluctuations can be unsettling, but over an extended period, the market tends to deliver positive returns. By staying invested and avoiding knee-jerk reactions to market volatility, you can benefit from the upward trajectory of the market and increase the likelihood of achieving your financial goals.

Combing Drip investing into a diversified strategy complements the long-term approach by smoothing out the impact of market volatility. By investing fixed amounts at regular intervals, you purchase more units when prices are low and fewer units when prices are high. This strategy reduces the impact of short-term market fluctuations on your investment performance and allows you to accumulate more units over time.

Case 1: A 30 year old Invests €100 per month in a Guaranteed With profits Pension Plan until Retirement age of 65

Locally, there are a number of Pension Plan providers offering Capital Guaranteed Plans with the under lying investment being such With Profit Funds. Calculating a rough average of the return in the last 10 years, this varies between an average 1.5% to 2.6% per annum. In the last 5 years, annual returns were even lower, and these averaged slightly below 2% and as is case of a number of providers having returns of 1% or even less per year.

Let us imagine a positive scenario and say that over the course of the 35 years, the investment returned an average annualised return of 2.75%. This person would have invested . This person would have invested €42,000 across 35 years, which appreciated by a further €29,000, and having a final pension pot of €71,000.

At face value, this may look like a good investment. However besides the fact that €71,000 today will be worth much less in 35 years’ time because of inflation, choosing such a strategy, the major risk is in fact the opportunity cost inflicted by choosing a capital guaranteed strategy for a long-term diversified, drip investing strategy with a much stronger compounding or snowballing effect.

This risk is the equivalent of a football manager opting to play the star of the team as a striker with aim to score many goals when in fact he is a star goalkeeper whose capability is to prevent rather than score goals. And we shall see why below.

Case 2: A 30 year old Invests €100 per month in a Global Equity Strategy until the age of 65

Let us start with another one or two facts. The global equity market rose around 10% per year in the last 10 years notwithstanding a global pandemic, a war and other political and economic issues. As an official and precise statistic, in the last 10 years (up to April 30th, 2023), the MSCI World Index has had an annualised return of?9.29%, meaning that $100 invested on April 30th, 2013, would be worth $243.11 on April 30th, 2023.

Taking another index and over a much longer period of time, the average yearly return of the S&P 500 is?10.359%?over the last 100 years, as of the end of April 2023. This assumes dividends are reinvested. Dividends account for about 40% of the total gain over this period. Adjusted for inflation, the 100-year average stock market return (including dividends) is 7.219%.Over the past 10 years, it rose 12.39% per year and 9.48% when adjusting for inflation.

In the below computation, unlike the first example, I took a very conservative 7% annualised return to account for underperformance and management fees.

This example speaks for itself and explains all the above features of drip investing and compounding over the long-term. The €100 monthly outlay across 35 years resulted in the €42,000 invested growing by €135,000 and resulting in a total pot of over x4 in value i.e. €177,000.

The risks here are higher volatility and a high probability of some negative years which in reality, such bad years will most likely result in being amongst the most profitable years across the course of the whole duration.

Case 3: A 30 year old Invests €100 per month until retirement age in a Balanced Strategy of 60% exposure to equity and 40% to Bonds also known as a 60/40 Portfolio

In this case, I shall take another MSCI index as a benchmark, this time using the MSCI PIMFA Private Investor Balanced Index which aims to represent the investment strategy of an investor seeking a balanced approach through a 60/40 portfolio. The annualised return in the last 10 years was 6.07%.

In my below computation, I will take a 4.5% annualised return to account for management fees. This would result in a pot of circa €102,000, where total growth also outpaced the total outlay but to a lesser extent.

Results & Conclusion:

As can be evidenced above, making the most of your pension plan investment requires selecting the right strategy. Unit-linked strategies that invest in a mix of equities and bonds offer greater profitability over the long term compared to "with profits" capital guaranteed policies. The higher?the exposure to equities, the more one is likely to get out of the years spent building their pension pot.

At the same time, embracing drip investing and harnessing the power of compounding can significantly enhance your pension plan's value. Additionally, risk can be contained through diversification, a long-term approach, and drip investing, helping you achieve your retirement goals with confidence. It would also make a lot of sense to scale down the risk when one is approaching retirement by scaling down on equity exposure. This presentation is for educational purposes only and should not be relied upon for any other use. Therefore, it is always best to consult with a trusted financial advisor to tailor an investment strategy that aligns with one’s unique circumstances and risk tolerance.?

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?Darran Agius

Employee Benefits Schemes Manager

Email: [email protected]