Making Cents: Time is money and money is time
I WROTE an article a couple of months ago about a lady I encountered who was coming close to retirement and I was telling readers about how much her pension fund and company shares went down in value by last year.
If you can’t remember or didn’t read the article it doesn’t matter. What you need to know is that over 12 months, her pension fund dropped by €154,000 and her shares fell by €159,000.
And primarily, the reason her pension fund in particular went down by that much was because she was invested in two very high-risk funds - funds that were appropriate for someone aged in their mid-20s, not someone two years away from being 60.
You see, in theory the younger you are the bigger your exposure to equities should be and as you get older, that exposure reduces because you have less time to take on risk because your recovery runway is shorter should values fall.
Anyway, very long story short, this wasn’t happening with her and her exposure to high- risk remained very high.
The traditional way of looking at how much you should be invested in equities and any other asset classes is typically determined with reference to your age. And there is a particular rule of thumb, known as the 110 rule, which is a useful guide in helping people decide how their fund should be structured.
And the 110 rule is based on subtracting your age from 110, and that’s the amount you should hold in equities, with the remainder going towards government and corporate bonds, cash, property and so on.
So, in theory if you’re 40, your asset split should be 70% in equities and 30% in the remaining asset classes.
There is a second method of determining what your % split should be and it comes from the results of a risk questionnaire, where the answers to about 12 multiple choice questions try to uncover what your personal appetite for risk is.
And again a useful exercise to carry out if you’re ever in doubt about how your fund is or should be set up.
Once you know what your number from the 110 rule is along with the results of the risk questionnaire, you then choose a fund that is aligned ideally to both. So, if the questionnaire suggests your appetite for risk on a scale of one to seven is a four, and the equity content of a fund with this credit rating is about your age minus 110, then you invest in a fund which has a risk rating of four.
So, both are the two most-used methods of determining how much your exposure to equities should be and equities are typically the most volatile asset class in a pension fund.
But I’m going to put in front of you another way of looking at how much you should be exposed to equities and what your risk tolerance should be, and equating monetary loss with time loss.
Bear with me and let me explain because it’s not as boring as it might sound.
We take risks to generate returns that will help us build a fund that will pay us an income that will last us for as long as we are alive. That’s the theory at least.
We also do it because it will help us reduce the amount of time we need to work. The more we make, the less time we have to work, right?
Looking at your finances in this light might help calculate your risk tolerance better than any risk profiling questionnaire could ever do, or looking at your fund with reference to how old you are.
You could measure it another way by looking at how much time you’re willing and able to spend working in order to make up for any losses you incur.
So, would you be willing to work an extra three years if you had to because your fund reduced in value by 20%?
Or is that length of time too much?
It’s another way of looking at a loss and putting some meaning behind what a loss of something like 20% means.
You can monetise the 20% and it might be a loss of say €40,000 which isn’t good but sometimes people might find it hard to figure out what that actually means other than seeing their fund go down by that value.
But, if you say the 20% means you have to work an extra five more years to make up for it, it has much more meaning, I think.
And it may influence the type of risk people take on. And depending on what they need, they could dial back their risk based on knowing the impact, or perhaps they simply can’t because they have to take on a higher risk because maybe they started late saving and need higher returns because they’re starting from a lower base.
Anyway, the formula that will help work out what your risk tolerance level is in this regard is: our fund value x reduction in value % / your monthly gross income.
Let me give you some examples to show you how this works in practice.
Example 1
Let’s say, your fund value is €350,000 and you earn €4,000 per month. If markets declined by 35%, you’d have to work an extra 2.5 years to make up for the loss. €350,000 x 35% = €122,500 / €4,000 = 2.5 years.
Example 2
Same parameters as above but with a decline in value by 20%. €350,000 x 20% = €70,000 / €4,000 = 1 year 5 months.
Example 3
Same parameters as above but with a decline in value by 10%. €350,000 x 10% = €35,000 / €4,000 = 9 months.
And the number of months is probably more because you have to pay tax on your monthly income and it’s unlikely you’ll be able to put all of it back into your pension fund because you have to pay for your cost living expenses, but for the purpose of this exercise, let’s keep it simple and use your gross monthly income for example purposes.
And when you do, you’ve got to ask yourself whether you’re willing to work an additional five years or three years or one year to make up for any loss?
If the answer is no, I don’t want to work an extra five years, then your risk exposure is probably too high but if you are, then your risk could be fine.
Maybe you fall into the first example and you’re okay with working an extra 2.5 years, if the value of your fund fell by 35%.
Because if you’re taking on that level of risk, on the flip side the level of reward if things go well will mean your fund will go up much more in value and you could in fact fast forward retirement.
There’s a saying that time is money but when you apply it to your pension fund and your risk profile, I think it reads better if you flip it and say, money is time.
And the more you value your time and the less of it you want to spend working, then perhaps you need to know how much longer you might have to work to make up for any losses you incur.
But again, how your fund is structured will depend on many other factors other than just how much longer you might have to work i.e. years to retirement, how much you’ll want to spend each month and how much you are saving each month, how much have accumulated to date, annual returns etc.
But maybe adding this new variable to the mix is something worth giving some thought to as well.
Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at [email protected] or www.harmonics.ie