Volatile stock markets
Looking at the FTSE 100, it is currently down 12.8% from the start of 2020. The low point came in March with the index down 34.1% on the year. We have seen a significant rebound, and there are hopes that mass vaccinations will reduce the impact of Covid-19 in the future. It is worth noting that Brexit negotiations also held back the FTSE 100. The recent agreement between the UK and EU has removed at least one dark cloud from UK markets.
INSERT MB Covid Pension Article Image 1 / alt text: graph highlighting FTSE 100 performance in 2020
As you can see from the graphs below, worldwide stock markets have been extremely volatile since February 2020. The leading US stock market indices, the Dow Jones Industrial Average and the NASDAQ, have recovered strongly. The Japanese Nikkei index also rebounded over the year. The European EUROSTOXX 50 index has struggled, although this is also a consequence of Brexit. This has impacted pension fund investments, and many people are concerned about the short to medium-term outlook.
INSERT MB Covid Pension Article Image 2 / alt text: graph highlighting international stock market performance in 2020
Defined contribution and defined benefit pension schemes
When looking at the impact of stock market volatility on pension funds, we need to differentiate between defined contribution and defined benefit schemes.
Impact on defined contribution pension schemes
As defined contribution pension schemes are dependent upon the value of the underlying investments, there is more risk associated with this type of pension. However, whether you contribute to a personal pension or via a defined contribution employer scheme, there are still various options available. Those who are approaching, or have just moved into pension drawdown, could feel the most significant impact in the short-term.
Impact on defined benefit pension schemes
In theory, short term stock market volatility shouldn't impact pension benefits accumulated via a defined benefit pension scheme. These pension benefits are related to final salary and years of service. The main concern for many defined benefit pension members is the financial strength of the underlying employer. However, in the event of difficulties, there are regulatory protections and various short to medium-term options.
How to protect your pension benefits
Amid volatile stock markets and wildly fluctuating pension fund values, it is easy to panic. You can take several actions to protect the short, medium and long-term value of your pension assets.
Defined contribution pension schemes
Those with defined contribution pension arrangements will be more acutely aware of stock market fluctuations. Remember to take financial advice before pursuing any of the below actions.
- Reduce short-term withdrawals
If at all possible, where you are currently in drawdown and taking pension benefits, consider a short to medium-term reduction. By reducing withdrawals in the short to medium-term, this should allow your pension fund to benefit from an expected medium to long-term recovery in stock markets and other asset classes.
- Delay retirement
Where there has been a significant hit to your pension fund assets, there may be an option to extend your working life, delaying your retirement. The idea is simple; this would, in theory, allow your pension fund assets to recoup some of the recent losses brought about by Covid-19 and Brexit. In the event of a short sharp recovery in stock markets, your pension fund assets may recover to an extent where you can revert to your previous pension date.
- Increase contributions
Whether you contribute to an employer defined contribution scheme or a personal pension, you could benefit from a short to medium-term increase in contributions. This would allow you to take advantage of current depressed stock markets. The longer you have until retirement, the greater the potential upside. Unfortunately, not everybody will be in a position to increase their contributions at this moment in time.
- Switching asset classes
As countries worldwide continue to roll out mass vaccination plans, there is hope for the future. While markets, in general, should recover, individual sector and company performance will vary wildly. It may therefore be sensible to approach your investment adviser about switching your pension fund assets. Some sectors will recover quicker than others while unfortunately, some companies may never recover. It may even be worth looking at collective investments in the shape of investment trusts or unit trust.
- Approaching retirement
If you have a managed defined contribution pension scheme, you will likely experience a switch to less volatile assets as you approach retirement. Consequently, a switch to yield-based "near-cash" investments such as government bonds, would offer a degree of protection from the recent stock market volatility. This is something that your pension fund advisers should discuss with you regularly, and more so as you approach retirement.
Defined benefit pension schemes
The challenges facing members of defined benefit pension schemes are very different from those with a defined contribution pension. That said, there are still many actions that you might consider to protect your long-term pension benefits.
- Employer contributions
Defined benefit pension schemes are regulated to ensure that long-term pension commitments can be fulfilled. Consequently, it is possible to increase and reduce short-term employer contributions to reflect a shortfall or surplus at the time. Where your employer proposes a reduction in their level of contribution, they will need to consult with pension trustees and pension fund members. If the proposal is in the long-term best interests of pension fund members, it will likely be authorised.
- Funding surplus
Defined benefit pension schemes are set up in such a way as to ensure that even volatile short-term fluctuations should have minimal impact in the longer term. As you can see on the above chart, the Dow Jones Industrial Average index has recovered and even exceeded the level it was at before the emergence of Covid-19. Those who panicked and switched to cash at the bottom of the market have lost out on the partial recovery. A conservative approach to fund management, and pension fund liabilities, can certainly yield benefits.
- Closure of defined benefit pension scheme
Defined benefit pension schemes, often referred to as final salary pension schemes, are few and far between today. As salary and length of service determine the benefits, employers must make up any shortfall in pension fund assets. If your employer decides to close their defined benefit pension scheme, they must consult with trustees and fund members.
In a worst-case scenario, future pension contributions would be switched to a defined contribution scheme. However, pension benefits accumulated in the defined benefit pension scheme would be ring-fenced and frozen at the point of closure. You would not lose your accumulated benefits, although you may be offered an enhanced value to switch them to a defined contribution scheme. In this case, it would be vital you take independent financial advice.
- Sponsoring pension fund employer goes bust
Unfortunately, we are likely to see many companies go out of business due to Covid-19. If there are insufficient assets to cover pension fund liabilities, the Pension Protection Fund (PPF) may take over the scheme. The PPF is a regulatory body which guarantees 100% of pensions for members already in receipt of pension payments. Those yet to reach retirement age would see 90% of their benefits guaranteed subject to a funding cap, which currently stands at £41,461 per annum.
First and foremost, you should see pension fund investment as a long-term commitment. The longer you have to retirement, the greater the potential to recoup recent losses. Initial stock market falls were predominantly as a consequence of the “unknown” with regard to Covid-19. Even though infection rates and in many cases deaths are more significant than the peak in early 2020, stock markets have not retraced the depths of previous falls. There is more visibility, light at the end of the tunnel and much of the previously “unknown” impact on economies, is now much clearer.
Enhanced regulatory protection
Even though the UK government recently relaxed pension fund regulations, offering greater flexibility and control over investments, you still need to take a balanced approach. Historically, as defined contribution pension fund members approach retirement, their investments tend to be switched into less volatile assets. This allows for a greater degree of visibility and stability to fund future payments.
The situation with defined benefit pension schemes is a little different. The majority of schemes will be unaffected by short-term stock market fluctuations. Even in the event of the sponsoring employer going out of business, there is protection in the shape of the PPF. While it is sensible to carefully monitor your pension fund assets, especially during these difficult times, it is important not to panic.