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How do I start to build a retirement fund?

This reader wants to make the best total return possible over the next 40 years
September 24, 2020, Adrian Lowcock and James Norrington

Liam is age 23 and earns just over £52,000 per year. His biggest expense is his rent of £1,100 per month and he has no debts.

Reader Portfolio
Liam 23
Description

Workplace pension invested in multi-asset fund, specialist equity and bond funds, cash.

Objectives

Build up retirement savings, make the greatest possible total return over the next 40 years, set an appropriate asset allocation, build up three months' salary in cash.

Portfolio type
Investing for growth

"I am just beginning my career and will retire at maybe age 70, so my investment time horizon is several decades,” says Liam. “I am looking for the greatest total return possible over that time period, and don’t mind whether I get it from capital growth or income yield. 

"I live quite frugally and suspect that I could live like a student for another few years.

"I contribute 5 per cent and my employer contributes 4 per cent of my gross salary into my workplace pension, which so far is worth about £4,300. And as I have now worked at this company for two years, if I put in 10 per cent of my monthly salary my employer will contribute 5 per cent. 

"I have invested my workplace pension in B&CE The People's Pension Global Investments (up to 100% shares) 0.5% (GB00BYY2NK05). This is the riskiest option given the high equity weighting – about 88 per cent at the end of July.

"Otherwise I find it quite daunting to get a good view of the big picture and work out an appropriate asset allocation as I am a complete beginner. But I do have some understanding of finance, and recently put £5 on Burnley to win against Norwich City and cashed out with a £5.60 profit at 1-0 up!

"So my key question is what investment class will give the highest total return over, say, a 20 to 40 year time horizon? The portfolio doesn't need to be liquid and, because of my investment horizon, I am comfortable taking a little more risk, though would prefer not to invest in direct share holdings.

"When should I be investing in bonds rather than equities, and is it worth investing in property over the long term? Other than my workplace pension I have £350 in the Baillie Gifford High Yield Bond (GB00B1W0GF10) and £200 in First State Global Listed Infrastructure (GB00B24HK556) funds.

"I also have about £5,000 cash and, as I want to have about three months’ salary saved before I invest further, intend to put another thousand into this asset. This would mean that if I lose my job I will have at least three months' living expenses while I look for another job. And if things got desperate I could ask my parents for maybe £2,000. That said, my performance in my job has been strong, and my company is growing quickly and has survived coronavirus so far."

 

Liam's portfolio

HoldingValue (£) % of the portfolio
Baillie Gifford High Yield Bond (GB00B1W0GF10)3503.55
First State Global Listed Infrastructure (GB00B24HK556)2002.03
B&CE The People's Pension Global Investments (up to 100% shares) 0.5% (GB00BYY2NK05)4,30043.65
Cash5,00050.76
Total9,850 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS INVESTOR'S CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You ask which investment class will give the best returns over a 20 to 40 year time horizon. Nobody knows, and anybody who claims they do is a fool or charlatan. You cannot get a view of the big picture because there simply isn’t one.

Economic theory, however, does have an answer – equities should outperform bonds because they are riskier. But over the past 20 years this theory has been wrong, in so far as UK equities have under performed bonds by 1.8 per cent a year during this time.

This might be just bad luck. Conventional theory predicts only a small out performance of not much more than two percentage points, depending on how you run the numbers. This means that even if the theory is right there’s a significant chance of shares under performing bonds - even over a 20 to 30 year time horizon. But the theory also suggests that the odds favour equities.

And it shows that investors have underrated the importance of some powerful forces pushing bond returns up. Some of these have been quite benign: ageing populations in the west, a savings glut in the Middle East and Asia, and a shortage of safe assets have raised demand for bonds and their prices. If these forces remain and investors are still under-weighting them, the next 20 years might be like the past 20. We’ll get good returns on bonds and OK-ish ones on equities.

But there’s a much nastier possibility. Bond yields have fallen because economic growth has been consistently disappointing, in part because returns on capital have been in decline with the exceptions of a few firms. If this continues, the outlook for shares is terrible.

This suggests to me that a long-term investor should not be fully invested in equities, but hold bonds or cash as well. It also means that your equity holdings should be diversified internationally, including in emerging and frontier markets as these spread the danger that mature western economies will continue to stagnate.

It’s through this prism that we must view the prospects for property. It has done well in the past 20 years because interest rates have trended downwards, and there’s a huge correlation between bond yields and the ratio of house prices to earnings. A repeat of the last 20 years is, however, only one possibility. One risk is that interest rates gradually rise, perhaps as economic growth improves. This would compress ratios of house prices to earnings.

Another risk is that rates stay low because of prolonged stagnation, but this too would depress house prices because they would remain unaffordable.

Right now, housing is expensive by historic standards, but equities are not. For me, this is a strong reason to favour equities over property, though not be fully invested in them over the long-term. But you do not need to take a long-term view if you can change your asset allocation any time, meaning that your time horizon is only as long as it takes to review your portfolio. And this means that we don’t need to confront the enormous uncertainties over the long-term.

So I think that you should keep on doing what you’re doing – making regular monthly investments into a fund that is mostly invested in equities.

 

Adrian Lowcock, head of personal investing at Willis Owen, says: 

You are saving for retirement in around 40 years which appears to be a realistic timescale. However, life is likely to get in the way of your plans and you may end up with other, shorter-term goals you hadn’t thought about. These could include buying a house, having children or a career change. Investing is not just about being able to afford the life you want, but also giving you options as it is likely that life will throw you a curveball. 

For this reason, liquidity is very important and you need to make sure that some investments are accessible if you really need them. So it makes sense to put some of your investments into an individual savings account (Isa) and not put everything into a pension.

 

James Norrington, specialist writer at Investors Chronicle, says:

Over the very long-term equities have been the best performing asset class on a total return basis. The Credit Suisse Global Investment Returns Yearbook, written by Elroy Dimson, Paul Marsh and Mike Staunton, shows that between 1900 and the end of 2019 the annualised real rate of total return from global equities was 5.2 per cent, versus 2 per cent for US Treasury bonds.

But that doesn't mean there won’t be periods – sometimes quite long ones – when other asset classes do better. For example, between 2000 and the end of 2019 the rate of return on US Treasury bonds was 4.8 per cent versus 3.1 per cent for equities. This out performance was driven by low interest rates and quantitative easing which sent bond prices to stratospheric levels, and the impact of savage bear equity markets in 2000-2003 and 2007-2009.

This highlights the importance of asset allocation. If you have a long timeframe and don’t need to access your capital right away, you can put most of your investments into global equities and expect them to do the 'heavy lifting' in terms of generating returns. But you should also hold bonds and other asset classes to smooth out those periods when equities do badly.

Of course, the past doesn’t predict future performance, and the negative correlation between equities and bonds can break down. This happened when the US Treasury market sold-off earlier this year at the same time as global stock markets fell. But there are a variety of complex factors that influence how different asset classes behave in times of stress, underscoring the importance of not having all your eggs in one basket.

 

 HOW TO IMPROVE THE PORTFOLIO

Adrian Lowcock says: 

As a new investor, you have a fairly blank canvas on which to build a portfolio and can use this to your advantage. The key to investing successfully is to take small and simple steps. A good starting point is to make a plan of what you want your portfolio to look like – basically a percentage of how much you want in each region.

Over 40 years, equities are likely to give the best returns but can be volatile so holding other assets can help to protect your capital.

There are long-term trends such as technology, environmental, social and governance, and healthcare. But valuations and events can change investment opportunities materially, so it is unwise to invest all your assets in one sector or country. 

I would start with a core global equity fund. These tend to have exposure to some of the world’s largest and best companies – the ones their managers think will deliver the best growth or income. Fundsmith Equity (GB00B41YBW71), for example, invests in companies its manager Terry Smith thinks will grow over the next couple of decades.

I would first build such a core fund to a reasonable size, say £2,000, before adding additional funds. UK investors often have a bias to this country. So it is important to make sure that you get exposure to other areas such as the US, China, Asia, and emerging markets which offer long term growth and exposure to the technology and biotech industries.

 

James Norrington, specialist writer at Investors Chronicle, says:

An appropriate asset allocation for you depends on your circumstances, how long you are investing for and your risk appetite. Conventional wisdom says that young people can take greater risk in their portfolios because they have longer to make good on any periods when markets fall in value. But that doesn’t mean you should cram your portfolio full of risky investments like small-cap stocks.

For someone at your stage in life, it wouldn’t be gung-ho to have around 60 to 65 per cent of your investments in equities, 30 per cent in bonds, and 5 to 10 per cent in other assets like gold, private equity or property-based investments. This is assuming that you have a steady employment income and some cash saved elsewhere for emergencies.

Buying your own home, preferably a freehold, should be an objective because with the cost of borrowing low, a mortgage is much better value than paying rent. However, while property as an investment is an easy concept to grasp, it is more complex than people expect and can be highly illiquid.

There is huge uncertainty over this asset at the moment due to shifts in behaviour caused by the coronavirus pandemic, but it could be worth considering some real estate investment trusts that specialise in areas such as warehousing for the non-equity segment of your investments.

At this early stage, good places to start would be a global equities tracker fund, and an active bond fund with a moderate risk profile that invests in a variety of government and corporate bonds. As you build up your investments you could then add smaller allocations to equity investments that take advantage of themes like emerging markets or technology trends, and add specific types of bond risk like high-yield credit.

But don’t lose sight of what your core holdings are as these should form the foundation of your strategy as you build scale.