Unless you’re fortunate enough to be in a defined benefit pension scheme, you are pretty much at the mercy of the markets when it comes to the eventual value of your pension pot and your income in retirement.
Generally speaking, that requires people to make choices about how they want their pension pot to be invested, which inevitably comes back to risk appetite. The higher the risk, the higher the potential rewards, but the downsides in terms of volatility and potential losses are also magnified.
When it comes to establishing your appetite for risk, however, it’s important to remember that volatility and risk are not the same thing.
“Volatility refers to speed bumps in the market. So if you’re invested in risk assets, and anything other than cash is considered a risk asset, then we know that markets go up but can go down too, and that you can have bumps along the road,” explains Suzanne Cashin, financial planning director at RBC Brewin Dolphin Ireland.
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Risk, on the other hand, is the possibility that “you might permanently lose your pension, or your savings capital, and not reach the financial goal you want to reach. A lot of people get volatility and risk mixed up.”
You only have to look back at the volatility the markets experienced when Covid hit to see the difference.
In the early stages of the pandemic markets dropped 30 per cent. “Clients got understandably agitated but the risk was that they would decide to sell out at the bottom and go to cash, which would have meant missing the return in market when it recovered, locking in that loss,” Cashin explains.
It’s important to recognise that risk comes in all sorts of guises too. “It wears many faces. Obviously a risk is that the value of your money will go down, which psychologically nobody likes. But there is also a real risk that if you don’t take some investment risk, your money doesn’t keep pace with inflation, and you end up with an outcome you can’t afford in retirement,” she says.
Changes made since the financial crash require financial advisers and brokers to undertake detailed “know your customer” surveys of each client, part of which is around risk.
“These are psychometric tests typically done online and usually pretty accurate as a starting point,” says Cashin.
They then open up a much more in-depth conversation around risk appetite and aversion, including in relation to pension planning.
For example, a 40-year-old client with €300,000 in savings and a desire to buy an apartment in three years is on a different journey than one whose goal is to retire at the age of 60, Cashin points out.
Sometimes gender, too, is a factor in relation to risk. Women typically map lower than men when it comes to risk assessments, she explains.
“There is a perception that women are risk averse but I believe they are risk aware. Women are more focused on what they could lose, whereas men tend to be more focused on what they can make,” she says.
With defined contribution pension schemes, the advice has traditionally been to start derisking your retirement investments in your 50s.
But with so few opting to purchase an annuity and so many more choosing an approved retirement fund (ARF) instead, that advice has changed. “If you’re retiring at 60, and going for an ARF, it means 75 per cent of your money will be invested for, possibly, another 30 years,” says Cashin.
Taking your 25 per cent lump sum, and the mandatory draw downs once you have retired, is a form of derisking. But choosing to take all of it as cash will likely see it nibbled by inflation. “The real value of your money is being eroded if you take a zero-risk approach with your pension fund,” she explains.
That’s why it’s so important to talk to an adviser.
“If you purchase an annuity at retirement age, that’s it, the deal is done and you’ve permanently surrendered your pension capital for a guaranteed income for life. But if your plan is to stay invested, then derisking may not be the right option for you.”
