#34 - What Pension Funds Teach Us About Life
Risk, Diversification, Experts
Over the past few weeks, I’ve written about superhuman feats of endurance, the Olympics, Trust, and some of my favourite books. This week, something far more exciting.
Pension funds, specifically ‘target date’ pension funds might not seem like a particularly interesting topic. However, since revisiting some of mine in the past week, I’ve found some insight in them that I felt were worth exploring. I’ll let you be the judge of whether I’m right…
A target date investment fund is a long-term financial investment account that is automatically adjusted over the years as the investor approaches a specific milestone such as retirement.
A fund is managed using this predetermined time horizon to inform investment strategy. This strategy typically relies on riskier investments in the early years, gradually moving toward ‘safer’ investments in later years.
These funds generally include the target date in the fund name. For example, a Target Retirement 2050 Fund is designed to reach the investor's objective and be drawn down in 2050.
The above diagram shows an example fund, and the change in the mix of investments as the target date approaches. Where the target date is still many years out, the allocation to "riskier" investments is higher. As the target date nears, this adjusts to a smaller allocation to these riskier investments and more to bonds and cash (safer).
The intention is to generate gains while the investor has plenty of time to recover from short-term losses. In later years, the investments lean towards more conservative options to consolidate gains and avoid untimely losses. Losing 20% of your pension because of a stock-market crash is going to hurt a lot more a month before you retire than it is when you're in your thirties.
That’s the finance lesson over. What is it that we might be able to take from these things and apply to other aspects of life?
Long-term planning is one, but that’s obvious. See rule #15 for my advice on making long-term thinking a little bit easier.
Instead, today I’m focusing on Risk, Diversification and Experts.
Risk
The approach of target date funds to relative risk based on your life period is obvious. They advocate taking risks earlier in life and a safer approach when the target date is approaching. As mentioned, this is so an investor can ride the growth and any potential declines in risky assets in the period where they are still accumulating.
This made me think about the broader concept of risk-taking. Taking risk is neither inherently good nor bad, and whether a risk is a good one or a bad one entirely depends on its nature and circumstance. Therefore, "take more risk" is bad advice in and of itself, regardless of your age.
However, most would advocate a bias toward risk in early years. People in their 20s, in particular, should be encouraged to have a very open relationship to risk, where the definition is to try different things and get out of comfort zones. A risk might be moving abroad, changing jobs, or putting yourself out there, even if it means coming up against a fear of failure.
Taking these risks in early life means exposure to significant potential upside and excitement, safe in the knowledge that even if they go wrong, you have time to recover and take a different path, hopefully with some sort of safety net in place.
In later life, the obvious conclusion from how a pension fund is structured might be that it is time to take fewer risks and start playing it safer. I take something slightly different.
It is important to reach this period in life in a position where you can still take the risks that you want to take. To do so, you want to have developed economic security, enabling the decisions to be entirely yours and not dictated by circumstance.
If you want to retire, slow down, travel, or donate, you need to make sure you are in a position to take risks by eliminating financial risk as much as possible.
Diversification
Even in the riskiest period of a target date fund, it is extremely unlikely that a fund would put all eggs in one basket, all chips on one number. Looking at my Vanguard account, I am invested in one fund, which has my money in 9 different regions and at least 10 different indexes. There is not one individual sector that has more than 14% of my money.
I am often torn between the psychology of going all in on one endeavour versus having multiple running alongside each other. Personal diversification, if you like.
Common wisdom might tell us it’s worthwhile to be diversified in life too. Not relying too heavily on one friend or group of friends, having multiple hobbies and ideas for what you want to do in the future. But, as with pension funds, this idea is grounded in playing it safe and ensuring things don’t go horribly wrong. In my Vanguard account, if the pharmaceutical industry suddenly implodes, only 3% of my money is at risk. The diversification is designed to protect me from significant losses.
However, if the pharmaceutical industry were to boom and valuations were to double overnight, my upside would also be limited. I would be exposed to something extraordinary, but I would have a 3% increase in my portfolio to show for it.
Diversification is critical for financial investments as it relates to protecting from ruin. This is probably also true in life, being a generalist with a wide selection of skills will likely mean you'll always have options. But it's focus and concentration that leads to extraordinary outcomes. Pick your favourite athlete, CEO or individual with a remarkable skill set. It's likely to be a sole dedication to a pursuit rather than diversification that got them there.
Pension funds are designed to accumulate wealth over the long term and then protect it. They are not intended to seek out 100 or 1,000x outcomes. This might also be true for careers and skills. Diversification might be the way forward if you are looking for stable and safe outcomes. However, genuinely exceptional returns - although much rarer - are found through complete focus on one thing.
Experts
Even just explaining pension funds is complex. Can you imagine needing to manage all of this yourself?
Let's imagine that there was consensus that managing your money through a target date fund was how everyone should go. Now suppose there was no automation or money managers like Vanguard or Fidelity to which you could set direct debits. Imagine, therefore, that you as an individual were responsible for researching, finding and making the investments, monitoring them for changes, making updates to your allocation and then closing them out as the target date arrived. You wouldn't do anything else!
Reliance on experts is something I’ve written about before. Firstly when I wrote about trust a while back and then last week when I spoke about Ross Edgley’s feats of endurance and the faith he puts in his team of experts. I’m going to write about it again.
During the 2016 Brexit debate, one of the lines parroted by the Leave campaign in response to Economists data showing that it might be a bad idea was, “this country has had enough of experts”.
This is still one of the most idiotic things ever said by anyone.
Without us having to think about it, experts make our lives immeasurably easier by reducing the amount we need to know. It means we don’t have to learn about how our cars work, how paracetamol is made and how financial instruments are used.
Learning what you can and not putting blind faith in corporations and individuals is important, but so is knowing when to take advice, when to put things on autopilot and when to let the expertise of others allow you to play life on easy mode.
Pension funds are an example of where letting the experts do their job and playing the system by smartly utilising what’s on offer can pay off. They are also surprisingly rich with ideas on how to think intentionally.
Thanks for reading, see you next week ❤️✌🏻