Faculty & Research -The pension fund challenge – how and when to invest in your future?

The pension fund challenge – how and when to invest in your future?

As retirement approaches, most people will be preparing to draw their state pension, or to benefit from a company-financed or individual pension fund. It is in the latter case where the major investment dilemma lies – when to convert a retirement investment plan that is prone to the highs and lows of the stock market into the more solid guarantee of a life annuity?

Timing is everything to ensure that the best possible return on investment is made at the prime moment. In an ideal world, retirement should rhyme with security, but getting a pension strategy wrong could leave the soon-to-be-retired at the wrong end of an “all or nothing” scenario….

Depending from country to country, a state pension is unlikely to be the most attractive financial option upon retirement, hence why so many people go down the company-financed or individual fund route. The United States is one of the most striking examples of this phenomenon, whereas European countries are relatively better served by the state system. The global financial crisis more or less put paid to the mutual fund, as most people consider it too risk-laden an investment option post-2008. However, knowing when to cash in a more volatile (for better and for worse) investment and turning it into a fixed “annuity” requires considerable know-how, whatever the type of fund. Beyond the basic risk factor relating to mortality and judging when the time is right to seek a financially secure future in retirement, maximising the future market value of an investment so as to get the best return when converting it into a lump sum is easier said than done.

Accumulating to consume

The investment approach breaks down into two phases: accumulation (during which an individual saves into a fund of stocks and/or bonds and, depending on the state of the markets, will make dividends upon the amount saved) and consumption (the decisive moment of cashing in the money invested, plus any extra money made upon that investment).
Phase two is the crux one – getting the best trade-off and an extra return from an insurer could just provide the extra protection needed against poverty in old age. Timing is key as converting into a life annuity is an irreversible process. Making the switch too early may not guarantee a sufficient yearly income upon retirement. Switching too late may bring in the mortality factor, as the individual may die before consuming all the money saved and made.

Getting value for money

Pension investment strategy carries an additional challenge – knowing what the money saved will actually be worth once it is freed up in the form of an annual income upon retirement. The “economic utility” of a fund is incredibly hard to predict. It is for this reason that investors should think more in terms of what experts call the Expected Present Value (which takes into account the mortality issue referred to above), rather than trying to second-guess what an unblocked pension fund will be worth in x number of years’ time.

Setting the boundaries

Given all the potential variables that could affect the performance of a fund and therefore the right time to cash in, investors should consider setting an upper and lower limit on the dividends due to be paid out and then act accordingly. In other words, if the fund is paying low dividends, the fund should be cashed in if its market value is above a certain level (a level that will decrease with time). However, if the fund is paying high dividends, the investor should only consider converting to an annuity once the fund falls below a certain threshold (which will increase with time).
This is all based on the perfectly logical reasoning that “annuitisation” (the act of converting a potentially volatile fund into a more secure pay-out) should be carried out before the value of a pension fund drops any further. The goal remains the same from the outset – to capitalise on savings and consume dividends in order to, at the very least, stave off poverty in retirement and, ideally, live comfortably thanks to a sound pension investment strategy.

Not all doom and gloom

The approach suggested above may put some people off of the potentially fraught business of managing a pension fund. However, being aware of the dynamics of investment during the accumulation phase (for better and for worse) is key to getting the timing right for conversion into an annuity and a securer future.
For future consideration and research could be a partial trading in of assets for an annuity payment, whilst retaining some investments on the market. Another model could involve the purchasing of deferred annuities, which would only be paid out upon retirement but the value of which would be protected in advance. In all scenarios, it has never been more important for future retirees to keep a close eye not only on their professional “D-Day” but also on the projected income on which they will live after D-Day and through to the end of their life.

This article draws inspiration from the paper Optimal timing for annuitization, based on jump diffusion fund and stochastic mortality, written by Donatien Hainaut and Griselda Deelstra and published in The Journal of Economic Dynamics & Control 44, 2014.

Donatien Hainaut is an associate professor of Finance and Accounting at ESC Rennes School of Business, France. His research interests include Quantitative Finance, Risk Management, Pricing of Financial and Insurance Derivatives, and Asset Liability Management
Griselda Deelstra is a professor of Mathematics at the Université Libre de Bruxelles, Belgium. Her research interests comprise Stochastic Modelling in Finance and Insurance, including Asset Liability Management, Risk Modelling and Measurement, and Pricing and Hedging.