When low investment risk means loss
How much investment risk are you taking with your own money just to pay annual fees to someone else? With more people than ever relying on their investment assets to provide essential income in retirement, the question of risk in relation to returns is becoming more pertinent.
Even in the bad old annuity-buying days it was accepted that as you moved towards retirement you should protect your portfolio with a shift from risky equities towards less risky bonds.
In the new pension environment, when more people will be 'living off the land' of their investments, the question becomes more nuanced - you will need to be backfilling some or all of what you skim off to keep your capital intact, or at least keep it from running down too quickly.
FEES: WHAT A DRAG
And as a Money Observer reader, you already know that old man Risk is happily married to the sweet lady of Returns. You don't get much of the latter without the former, so if you want or need your investments to grow meaningfully, in most cases you're going to have to take some risk.
But there is one certainty when it comes to investments - fees. One effective analogy is to think of your money like a bar of soap: the more people who handle it, the smaller it gets.
You may think that to avail yourself of multiple financial professionals would mean your money was in safe, knowledgeable hands and therefore better returns were assured. But the costs involved will be a constant drag on your portfolio that could pull you into neutral or even negative territory - especially when you take long-term inflation into account as well.
Let's say you're a cautious investor aiming for real returns (in other words, accounting for inflation) of 3 per cent to meet your investment goals, which sounds perfectly reasonable. If costs add up to 2 per cent, you will have to aim for returns of 5 per cent, and take on more risk to do so.
If you are facing a couple of decades of saving, having fees dragging down your returns every year means you will either have to take more investment risk to compensate, make bigger contributions, plan for less money in retirement or work for longer.
Phil Young, managing director at adviser consultancy Threesixty Services, says: 'Most people I've spoken to in the industry believe that 50-60 per cent equity exposure is required to beat inflation.
'But what's less clear is whether it's possible to beat inflation with less equity exposure if the industry's own costs are stripped out. Adding layers of costs for advice, platforms and the like will create an overall cost of 1.6 to 2.3 per cent, often regardless of whether you use a low-cost fund or not.'
Young looked at five typical model portfolios, each associated with a different risk level of one to five (see the end of this article). He found that, broadly speaking, over 10 years each successive risk level returned on average 0.82 per cent more (annualised) than the risk level below it.
In other words, if you're paying fees of 1 per cent - not unreasonable these days - you will have to take a whole step up the 'risk ladder' to meet your objectives, simply to make up for the drag of costs.
MOVING UP THE RISK LADDER
Here is the kicker, though: financial advisers want their customers to be happy in the knowledge that their investments are doing well. So when an adviser shows you a report on your portfolio net of fees, he or she wants to show you positive returns. It would be an awkward conversation indeed if a portfolio showed slightly negative returns - for example, an amount equal to the adviser's fee.
This gives advisers an incentive to put clients into higher-risk portfolios in an effort to gain higher returns - not necessarily because that's what's best for the client but because they need to make up for the drag created by their own fees. Of course, when fees are taken for granted, this is done in the name of meeting the client's investment objectives.
Let's use a hypothetical example. Sam is a very risk-averse investor. All things being equal he would prefer to keep his portfolio on risk level one.
However, he has a specific investment objective - building up a certain amount for a secure retirement - so he decides to extend himself a little and move to risk level two.
But when he takes fees and inflation into account he may well have to move up again to level three, just to stay on track to meet his objective of having enough to live on in later life.
'Each time you move up a risk level you get an extra 0.82 per cent in performance, but also an increase in volatility,' says Young. 'So if you strip out 0.82 per cent of costs (on average) you can, in theory, afford to take less risk.
'But in reality nobody knows what performance differential an active fund manager or an adviser will add, and it may well justify the cost.'
Young is careful to point out that it isn't only advisers and their fees that push people into riskier investments; indeed, some advisers will charge a one-off fee to set up a portfolio as a single piece of work, which means there is no ongoing drag on returns.
But another source of rising costs is the increasing number of funds only sold through a platform, rather than being available to investors who approach the fund house directly. The platform simply adds another layer to the cost onion (so named because of its many layers and its tendency to make investors cry).
THE COST ONION
When Jeremy Le Sueur, managing director of 4 Shires Asset Management, breaks down the layers of costs - especially those incurred during the set-up of your investments - the picture is truly daunting. Initial one-off adviser fees are often around 3 per cent plus VAT; if they give you an ongoing service this could involve an annual charge of 0.5 to 1 per cent.
If the adviser outsources to a discretionary fund manager (DFM), the DFM will likely take 0.75 to 1 per cent annually and possibly a dealing commission of 0.5 to 1.5 per cent when it buys and sells funds.
An actively managed fund might cost 0.75 per cent per year, and you will have to pay stamp duty on trusts and stocks at 0.5 per cent, as well as any other hidden costs on top. This presents an extreme picture, true, but it does give us an idea of how many layers of cost might be eating away at your returns.
'The investment time horizon and the level of volatility a client is prepared to accept are the two most important questions when assessing risk and portfolio construction,' says Le Sueur. 'Once a charging structure attaches itself limpet-like to an investor's money, then a required rate of return is important to cover the costs of the investment.'
And to make up for the costs, investors are typically having to accept a larger equity presence in their portfolio than they would otherwise need to get the same results - thereby pushing up the volatility of the portfolio.
'To get 3 per cent actual return after charges, a weighting of two thirds in shares or equity funds would be recommended,' says Le Sueur. 'Less than that and returns might fall below that level. With real equity return rates - that is, after inflation - at [around] 5.2 per cent according to Credit Suisse, that should give plenty of cover over say a 10-year period to cover market volatility.'
Even if you go down the non-advised route on an investment platform such as Interactive Investor or Hargreaves Lansdown, and manage to shave half a percentage point off your overall costs, this won't necessarily mean you can afford to hold less than two thirds in equities.
However, if you went the extreme low-cost route with exchange traded funds and index trackers, and brought your costs down to 0.3 or 0.5 per cent, Le Sueur estimates you could reduce your equity exposure to about 50 per cent.
But remember what we said about the bad old days of annuities? Here is where the idea of an annuity regains some appeal for risk-averse investors approaching or at retirement.
'There's a tipping point - a combination of client age, portfolio size and risk required - where the performance of a portfolio required just to justify the charges coming out of it means that an annuity is the best option,' says Young.
'It's worth bearing in mind that once you've bought that annuity, there really isn't anything else to think about or manage. Running a portfolio into retirement requires a level of engagement that many might not want to bother with, and will probably incur ongoing professional fees also.'
This isn't to say financial advice is to be avoided. Investors notoriously misunderstand the riskiness of a given portfolio, so an objective second perspective can be very helpful. But be wary of ongoing charges and the drag they add to your investment portfolio - you may find yourself climbing to uncomfortable heights on the risk ladder to accommodate them.
FEES MAKE DRAWDOWN HIGHER RISK
Then in the three right-hand columns, we list the rates of return you'd need to achieve to have your pot last to certain ages (85, 90 and 95) if you are drawing income at a rate to match what you would get from an annuity.
Importantly, you would pay no fees on your annuity income, and the required return figures in the right-hand columns do not account for fees. If you were paying 1 per cent in fees every year, for example, you would have to add 1 per cent to the return your investments would need to make.
Therefore if you are 70 and want your pot to last until you are 95, you will need returns of at least 5.7 per cent if you want to take income equal to what you could get from an annuity.