Deciding how to spread your money across different assets is the most investment important decision you'll ever face. Academic studies have shown that asset allocation accounts for the vast majority of returns over time – more than nine-tenths of whatever return you make will be determined by this one factor. By contrast, stock-picking and timing are responsible for the remaining one-tenth of returns, at most.
Yet most people focus mainly on stock-picking and timing. After all, everyone loves a hot tip. And whereas we all drool over the thought of buying into a share just before it really starts to rocket, it's hard to get nearly as excited over the dry matters like how assets move in relation to one another and what proportions of each we should hold in our portfolios. But this is precisely what theory and practice tell us we should do.
A Sipp gives you much greater influence over asset allocation than any other type of pension. This privilege also places a huge responsibility onto the individual and onto any advisors involved. You and they need to think regularly about your holdings and whether they are appropriate given market trends and also in light of your changing circumstances.
Mastering asset allocation takes time and effort. If you haven't got a firm grasp of these issues when starting your Sipp, make sure you've got an advisor who does. Here, we present some of the key things you need to know in your quest to becoming a highly effective asset allocator.
Have clear goals and strategy
It is absolutely essential to have a clear vision of what you're aiming for with your Sipp and how you intend to achieve that. You may think the answer is obvious: to make clever investment choices that leave you with the largest possible pension pot. While that's true in general terms, you need to be much more specific about both the means and the ends.
An investment policy statement (IPS) is a document where you set out in detail your long-term objectives. The IPS will then determine your day-to-day investment approach. If you've got an independent financial adviser (IFA), then he or she should automatically work with you to create an IPS. If you're running the show by yourself, it's just as important – if not more so – to commit your approach and objectives to paper.
The first step in creating your IPS is to estimate how much you're going to need to retire on and when. These are tricky questions that require you to make several big assumptions, especially if your retirement is several decades away. But it is crucial that you try and come up with some realistic numbers.
There are plenty of freely available online calculators that will allow you to reach rough-and-ready figures for how much you'll need to save now in order to meet your desired pension goals. It's better to go further than this, though, and play around with assumptions a bit, such as the size of your contributions and effect of delaying your retirement date. This exercise should serve to underline just how big the task of saving for retirement is and how you can make a difference by committing as much as you can from as early a stage a as possible.
Once you know how much you want to live on a year in retirement, you can calculate the required size of your pot when you come to buy an annuity or enter income drawdown. Then you can work out your required annual return requirement. This is a product of your current pot size, your target pot size, the left time to retirement, and how much you're paying in a month.
Your return requirement needs to be realistic, though, given the long-run average returns on various asset classes. For example, equities – the most successful asset class in the UK historically – achieved an annualised average nominal return of 10.6 per cent a year in the 20th century. Your requirement also needs to reflect your risk profile. While your goals may demand a strong weighting in risky assets between now and retirement, this may be totally inappropriate if you only have five or 10 years of working life to go.
The IPS should be the reference point for all your investment decisions. Because your circumstances – income, age, current spending needs – will change over time, your IPS will need to change with it. So you should aim to review it at least once a year or whenever there is a significant change in your personal finances. That may include redundancy payoffs, inheritances, divorces, unanticipated expenditures or windfalls.
The structure and essential information that you need for creating an IPS can be found .
It's team performance, not individual brilliance
Having formulated return and risk objectives, it's down to the business of achieving that target. Ensuring the right proportion of risky assets is very important. The earlier you are in your career, the more equities, property, commodities and other risky stuff you should have in your portfolio. With many years until retirement, your portfolio has plenty of time to recover from any near-term losses. Remaining invested during equity bear markets should frighten you much less than missing out on a bull market.
"Surprisingly, a lot of the research we've carried out suggests that people have too much of their pension in cash, even when they've still got 25 years left to retirement," says Peter Hicks, executive director of UK retail at Fidelity International. "Conversely, we also find that people nearing retirement often have too much of their wealth in risky assets, such as equities."
Getting a good spread of asset classes and a decent spread within each asset class is important. Admittedly, the highest potential returns come from being 100 per cent – or more – invested in the most successful asset class. Historically, that has been equities. But with a Sipp, you have more freedom to get exposure to other areas, particularly commodities and property.
For an idea of a possible asset allocation structure, we've included some charts based on data from IFA Bestinvest. The one shown is a model portfolio for an adventurous investor concerned with achieving growth rather than income. You can see a more extensive selection at http://www.bestinvest.co.uk/planning/portplan/index.htm.
But how do you get exposure to these various asset classes? If you've a full Sipp of a substantial size, the world can be your oyster. Not only will you have the keen assistance of an IFA, but you will have the wherewithal and a vehicle that lets you buy into some of the more adventurous assets out there, such as direct holdings of commercial property or truly 'alternative' assets – article for more on this.
For the smaller Sipp investor, especially those with more limiting execution-only wrappers, getting exposure to more exotic stuff can be a bigger challenge. However, there are still plenty of possibilities. For example, a range of 31 exchange-traded commodities (ETC) are now available on the London Stock Exchange. These allow you to get effective, low-cost exposure to classes of commodities – such as energy – or to individual ones, like soybeans.
But what if you don't have the time or skill to do your own asset allocation? A lifecycle fund could offer you an effective, low-cost way of achieving the diversification that you need. The idea is simple: the lifecycle fund does all the asset allocation for you, based on your stage of life. When your retirement is distant, the fund holds a high proportion of risky assets. As you age, it shifts into safer assets, just as theory dictates.
Lifecycle funds are huge in America, but haven't been around for long over here. Among the few available, Fidelity's funds are particularly interesting. "For someone due to retire at 65, our funds would still have them in higher-risk assets at age 50," says Peter Hicks of Fidelity. "Then about 14 years before retirement, we gradually start gliding down the proportion of risky assets."
While lifecycle funds are a clear improvement for people who currently pursue no asset allocation whatsoever in their retirement saving, they have yet to win over many pension professionals. "In principle, lifecycle funds are a good idea," says Tom McPhail of IFA Hargreaves Lansdown. "But, ideally, investors should engage with their own investment decisions on an ongoing basis. The lifecycle fund is never going to be quite as flexible as an individually determined approach."
Being asset allocators themselves, IFAs may see lifecycle funds as a threat. But lifecycle-fund providers are keen to stress this isn't the case. "I'd accept that the ideal situation is for each individual to have bespoke asset allocation," says Peter Hicks of Fidelity UK. "But a lifecycle fund is well suited to use by IFAs. It makes the job of servicing their lower-value clients simpler and cheaper. And once those smaller customers’ Sipp assets grow to a certain size, the IFA can switch those clients from lifecycle funds to a bespoke service."
Be disciplined
Having a Sipp gives you much greater freedom to invest in different assets than any other type of pension. While getting a balanced spread of different investments is desirable, you need to be systematic in the way you go about building a portfolio. A 'scattergun' approach to selection will not only risk producing inferior returns, but it will almost inevitably lead to higher costs, which will further depress the value of your pension.
Following fads is an obvious example of a bad investment habit for Sipp owners. The result of always jumping on the crowded bandwagon is almost always a ragbag portfolio of underperforming assets.
"Picking funds and shares in isolation is a common mistake," says Fidelity's Peter Hicks. "It happens a lot during Isa season – people treat it like choosing a horse to back for the Grand National. They take free-standing decisions, rather than conforming to a set plan that takes account of the investments that they've already made in previous years."
A much more sensible approach is to decide on a technique that you're comfortable with and to stick to it. Rules-based systems can be particularly helpful here, as they take a lot of the emotion and subjectivity out of the investment process. For example, you could pursue a value investment strategy, only buying shares that met the criteria of a proven system process, such as those that feature in the IC’s stock-screening service
A particularly neat system for running your Sipp's equity exposure is the ShareMaestro computer programme, – see also www.sharemaestro.co.uk. This computer programme performs a fundamental valuation of the FTSE 100 and tells users whether the index is cheap or dear at any given moment. A simple strategy emerges from this: buy an index tracker whenever the FTSE reaches a certain level of cheapness and sell up and switch into cash when it registers an expensive reading.
"In the decade to the end of 2007, the median annual total return for UK equity funds was a paltry 6 per cent," says Glenn Martin, developer of the ShareMaestro system. "By contrast, using the ShareMaestro system would have delivered an annual return of 11.3 per cent after costs. If this were repeated over a 40-year investment horizon, you'd earn seven times as much with ShareMaestro as you would with the median UK equity fund."
Of course, you don't have to use fundamental analysis to inspire your equity strategy. Gann Management offers a pensions management service based on technical analysis. Its experts use the teachings of WD Gann in order to identify entry and exit points for a whole range of assets, according to the client's criteria. Gann Theory says that significant highs and lows in financial markets are mathematically related, both by percentages and by geometric angles.
"For us, timing is everything in the markets," says Gary Stafford, technical director of Gann Management. "Our approach works because we ignore news and 'fundamentals.' What everybody else knows simply isn't worth knowing. We seek absolute returns and practise tight risk management. As a result, we've never lost money in any single year, not even in the bear market of 2000-2003." Mr Stafford has a very bearish outlook for equity markets and is invested in cash and index-linked securities while he waits for new Gann-derived opportunities to appear on the charts.
Minimise costs
Costs are an inevitable part of the investment process. If you're not careful, they can have a devastating effect on your investment performance and, in turn, upon your quality of life in retirement.
Using low-cost vehicles such as exchange-traded funds (ETFs) and other trackers is one way to stop fund managers eating up too much of your future pension. Minimising trading costs by following strict rules is also recommended.
Sipp investors really need to ensure that they are not paying for anything that they're not going to use fully. Some people are enticed into Sipps by the idea of freedom to invest across various asset classes. However, they end up not exploiting this liberty and simply investing in things they could have bought in a lower-cost personal or stakeholder pension – but with much less expense.
Plan your non-pension finances rigorously
Just as you should take a holistic view of the assets within your Sipp, rather than looking at them in isolation, so should you look at your entire finances this way. Your home and other assets all form part of your total wealth and may come to play a part in your future retirement plan. Think about these things sooner rather than later, and judge whether your asset allocation makes sense in light of your total assets and liabilities.
Making regular payments into your Sipp should be a top priority. For those whose income is lumpy – such as the self-employed or those who derive a significant proportion of earnings from commissions or bonuses – this requires extra attention. Because your income may go up and down, it’s important to make additional contributions in times of plenty. In the current tax year, you can get tax relief on your contributions on up to £225,000 or 100 per cent of your income, whichever is less.
Careful budgeting is the other ingredient in maximising your Sipp contributions. As well as controlling day-to-day outgoings, it’s important to model significant future expenditures and work out how you're going to cope with them. School or university fees for children or grandchildren are an obvious call on tomorrow's finances, and deserve discussion with your financial advisor on how best to manage them.
Review and rebalance
Asset allocation is a dynamic process. Financial markets and your circumstances are in a constant state of flux. For this reason, it is imperative that you review your IPS and strategy on a regular basis. Is your IPS still appropriate for your present situation? Should your weightings between different classes be adjusted to reflect your increased wealth or advancing age? Is a tactical change in order because of outstanding opportunities in a particular area?
Even if your situation and needs remain the same over a couple of years, the markets will most likely demand that you rebalance your portfolio. For example, a terrific run in commodities might naturally increase their weighting in your holdings from their target level of 10 per cent to 15 per cent. In these circumstances, harvesting some of the gains may well be advisable – otherwise, the market end up restoring the original weightings the painful way.
VITAL STATISTICS FOR A SIPP INVESTORS IPS:
• Your profile
• Your age and desired retirement date
• Your desired income in retirement
• The current size of your pension pot
• The necessary pension pot at retirement
• Your monthly contribution ability
• Preference between annuity purchase and income drawdown
Objectives
1. Risk tolerance
• Ability: determined by your existing levels of wealth and your stage of life. Risk-taking ability is positively related to the size of your net worth, and inversely related to your age.
• Willingness: determined by your emotional comfort levels with risk taking. Advisors should respect willingness ahead of ability.
2. Return requirement
• Determined by the current size of your pension pot and your ultimate target. It is essential to consider inflation and take a total return approach here.
Constraints
• Time horizons: the stages of your path to retirement. This could include periods of paying education costs, other major expenses, semi-retirement and so on.
• Liquidity requirements: includes any current spending requirements that will affect your contributions, any large significant expenditures in the future.
• Taxation: your current tax bracket and your expected bracket in retirement.
Unique circumstances
• Restrictions on holding certain investments on the grounds of personal beliefs.
• Likely developments that could affect your savings and wealth levels.
Assets outside of Sipp
• Your Sipp plan should take full account of your entire personal wealth.
• Other significant assets and liabilities outside of the Sipp should be considered. These might include Isas, other pensions, your primary and secondary residences, assets held in trust.
• Next scheduled IPS review date.
