No risk, no reward! Like many things in life investing inertia and fear are common but have a cost. A sponsor should be aware of what 'taking too much risk' means when selecting CAP investment options. There are ways to minimize this risk
In the investment world risk, ‘investment risk’ has a specific meaning: “the probability of losses relative to the expected return on an investment”. The key in this definition are the words “expected return”.
In the pension world the concepts of returns and risk are inseparable: both are compared against a bench mark which provides an ‘expected return’. The benchmark may be an equity or bond index such as the S&P/TSX (Canada), the S&P (US), MSCI (foreign equities) or the DEX-universal Bond Index. An ‘absolute’ measure such as a specific interest rate may also be used as the benchmark in certain conservative portfolios.
In assessing the performance of a mutual or pooled equity fund manager the returns and the difference or deviation of returns of the fund vs. the benchmark are closely monitored. The standard deviation of these differences is calculated for each fund and is referred to as ‘tracking error’. Tracking error is important: it reflects how much ‘risk’ the fund manager is willing to take by using a different mix of investments vs. The composition of the benchmark. A low standard deviation suggests that the fund manager invests in the same investments as the benchmark and in the same proportion. If the tracking error is significantly greater than the bench mark it indicated the fund manage risk taking on significant additional risk. Correspondingly, if there is higher risk vs. the benchmark a higher return is expected i.e. additional risk must result in an additional reward (higher return).
How to minimize ‘Investment Risk’
An awareness of the combined level of ‘risk’ in a portfolio of suite of investment options is of important to the CAP sponsors, mutual fund investors and individual investors. Use of the default fund in a CAP is often wide spread and has a potential ‘performance’ risk aspect for sponsors.
Investment risk, by definition, is directly related to the return performance of a benchmark. By investing in mutual or pooled funds or, constructing a portfolio that is very similar in composition to the benchmark (difficult), investment risk is minimized or eliminated.
This is a strong argument for the average investor to invest in passive or indexed funds. Exchange traded funds and passive equity or balanced funds which have low fees, are available. Low fees are a significant factor in maximizing your retirement savings accumulation.
CAP Sponsor (DC Plan) Perspective
From a CAP sponsor perspective offering a suite of passively managed investment options is a logical option. In providing investment options a CAP a sponsor only needs to offer prudent investment options; the options do not have to be ‘best’ performers.
Passive funds track the benchmark: divergence from the benchmark is the way risk is quantified. It would be difficult for members to argue that passive investment choices were too or not risky enough and reduces the risk of members challenging the investment options used in a plan. Investment options that track the market (benchmark) are neither too risky or not risky enough and have low fees.
Minimizing investment risk does not mean that losses will not occur in an investment portfolio: if the market and the benchmark are down the portfolio value will also be down.
Passively managed funds closely track benchmark and have low fees which is beneficial from a CAP sponsor perspective and minimizes legal risk.
For the average Canadian in taking on an appropriate level of risk the key and the a strong argument for having a comprehensive financial (retirement) plan with clear objectives and an appropriate (simple) investment strategy.
Managing Director, The PensionAdvisor