The previous blog “How is the value of my pension share calculated?” highlighted the process to be followed in calculating the amount of funds to be transferred on implementation of a pension share.
If there is a significant fall in the stock market from the date of the original valuation to implementation date it’s very possible the investment will have a significantly lower value than anticipated.
This issue can be dealt with by adjusting the risk profile of the investment.
Managing investment risk
Investment risk means different things to different investors. However, the most common definition is the risk of losing money, known as “capital” risk.
Most investors are aware that there is a clear link between risk and reward. The greater the return you are hoping to achieve, the more risk you will have to accept. But with that greater risk there is a greater chance of losing some or all of your original investment.
If you are saving or investing for the very short term it rarely makes sense to take investment risk because if you need access to your money in a short period of time it may have fallen in value without the opportunity to recover.
When you are investing for the longer term you can often afford to take more risk because your investments will have more time to recover from any short term market volatility.
In summary, taking more risk with an investment has the potential to give bigger returns. However, there is also the potential to lose more if the market drops. When the risk is lower the potential return is smaller, but the potential downside is also reduced.
The factors that determine investment risk
The amount of risk inherent in a pension investment will be governed by the mix of assets in the fund, known as the asset allocation
Asset allocation represents how the investment fund is split between the four main asset classes- cash, fixed interest securities (bonds), property and equities.
Various academic studies have shown that the asset allocation decision (i.e. how you split your investment across the 4 asset classes) has a bigger impact on investment returns than the specific fund selected.
A low risk portfolio will typically have higher levels of cash and corporate bonds. As a client moves up the risk scale the percentage of the fund held in cash will reduce, bond holdings will reduce and the percentage held as equity will increase. As the client begins to move up the risk scale, the equity holding will typically consist of UK, North American and European stocks. At the higher end of the risk scale typically the equities will be held in Asia or emerging markets, where there is the potential for greater return (and greater risk).
In order to estimate how much risk is inherent in a pension fund investment it would be necessary to have an indication of the split of the investment across the four main asset classes.
If the main bulk of the pensions are held in defined contribution schemes invested mainly in equities a way to reduce investment risk would be to adjust the asset mix to a lower risk profile. At an extreme the investment could all be held in cash within the fund. However, an alternative would be to adjust the holdings to provide a larger percentage holding in the lower risk assets, with much smaller percentage of the fund held in equities.
The downside to reducing investment risk
There is of course a downside to this…
If the market rises significantly over the period of the negotiations the pension fund will not benefit from this increase to the same extent it may have done if the fund had remained in equities. In the extreme case of the fund being all held as cash, the real purchasing power of the fund will drop. This is due to the fact that the cash return will not keep pace with inflation, and the costs of the pension provider will further reduce the return.
But this may still be a more favourable option to the option of leaving the investment in high risk assets which may then experience a large fall.
At the date of negotiation, the fund value could be up to a year old. There is therefore much scope for significant change in the current value of the fund compared to the value being relied on.
Is the pension fund different to any other matrimonial asset?
The same concern of a potential fall in value is of course true for all assets. The matrimonial home will also increase or reduce in value over the same period. The difference here though is that as a nation of home owners we are all very aware of roughly what our property value is. A quick look on one of the many property websites will give us a fairly good idea of the current value of the matrimonial home and other properties held.
This is not so easy with a pension, or indeed any other investment. The spouse who owns the investment may be able to obtain an online up to date valuation. However, the other spouse will have no access to this information unless it’s shared by the spouse who holds the investment.
The way forward
There is no right or wrong answer as to whether it would be appropriate to move the pension into lower risk assets. It will depend on the circumstances of each case, and the differences in risk profile of the 2 parties. The biggest effect will be where one party (often the wife) has limited pensions in their own name and will be wholly reliant on the value of the pension share for income a later age. If the value has dropped significantly when she receives her share she will be receiving significantly less income in retirement than had been envisaged during negotiations.
If you are going through divorce and would like advice on your finances please call me for a no obligation discussion on 01932 698150.
photo credit: flickr/images of money