No risk, no reward. Like many things in life, investing inertia and fear are common, but they come with a cost.
In the investment world, 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.’
When it comes to pension plans, the concepts of returns and risks are inseparable: both are compared against a benchmark that provides an expected return. The benchmark may be an equity or bond index, such as the S&P/TSX in Canada, the S&P in the United States, the MSCI for 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 versus the benchmark are closely monitored. The standard deviation of these differences is calculated for each fund and is referred to as tracking error. This is important because it reflects how much risk the fund manager is willing to take by using a different mix of investments versus the composition of the benchmark.
A low standard deviation suggests 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 benchmark it indicated, the fund manager risks taking on significant additional risk. Correspondingly, if there’s higher risk versus the benchmark, a higher return is expected, i.e., additional risk must result in an additional reward (higher return).
It’s important for capital accumulation plan sponsors to be aware of the combined level of risk in a portfolio or suite of investment options.
By definition, investment risk is directly related to the return performance of a benchmark. By investing in mutual or pooled funds, or constructing a portfolio that’s very similar in composition to the benchmark, investment risk is minimized or eliminated.
CAP sponsors can consider offering a suite of passively managed investment options. This minimizes the risk of members challenging the investment option used in a plan as being too risky or not risky enough. In providing a CAP, a sponsor must only offer a prudent set of investment options; the options don’t have to be ‘best’ performers. Investment options that track the market (benchmark) are neither too risky or not risky enough and have low fees.
Minimizing investment risk doesn’t mean losses won’t occur in an investment portfolio: if the market and the benchmark are down, the portfolio value will also be down.
Taking on an appropriate level of risk is key for the average Canadian, and a strong argument for having a comprehensive retirement plan with clear objectives and an appropriate investment strategy.
Gerry Wahl is managing director of the PensionAdvisor.