One of the major difficulties that the trustees of pension funds face today is finding investments that are not correlated with each other. Very simply, this means that different assets move in different directions in reaction to changes in the investment universe, so that one zigs while the other zags, to put it in its simplest terms.
The traditional formula for constructing a balanced portfolio that would be adopted by a pension fund, whether institutional or personal, was to hold various percentages of cash, fixed income and stocks (equities). The different asset classes behaved differently, with cash having zero volatility but usually generated low returns, bonds offered a reasonable income but were affected by changes in interest rates and stocks were the most volatile but gave exposure to the growth in the real economy. By combining these different asset classes, investors could come up with a portfolio that included the desirable features of each category while offsetting some the volatility that accompanied them, as they were not correlated with each other.
In the low interest rate environment that pension fund trustees and other investors face today, many of the advantages of this approach have been eroded. Cash now offers minuscule returns, and the yield on investment grade bonds, particularly those issued by the governments of developed economies, has fallen to 60 year lows, offering very little yield to offset any increase in interest rates, such as occurred in the first half of 2013. Meanwhile the volatility of equities has increased dramatically in the last decade, driven by the dominance of computer-generated trading systems, and stocks are not only more volatile but also much more correlated with each other. The volatility of the developed markets, as measured by the standard deviation of returns for the MSCI World Index, has increased by almost 50 percent over the last two decades.
Fortunately for individual investors looking to preserve the real value of their pensions through an INTEGRIS Personal Pension Plan (PPP) or a traditional Individual Pension Plan (IPP), the structure of this pension for incorporated individuals is extremely flexible, and allows investors to actually use the increased volatility of markets to their advantage. PPPs and IPPs assume a 7.5 percent annual return, and allow those making contributions to make additional tax-deductible contributions when the return from their underlying investment does not rearch 7.5%.
Thus additional contributions can be made after markets have fallen, allowing the contributor to buy at lower prices or higher yields than were available earlier, permitting them to follow the most pertinent piece of stock market advice- buy low, (and if so desired, sell high). This ability to hit the reset button as far as making contributions to one's pension plan permits investors to turn the increased volatility of recent years to their advantage, in a way that is not permitted or possible with the more widely known vehicles such as RRSPs or group RRSPs. In an RRSP, once a person has reached the maximum contribution for the year, no further contributions can be made without penalties. PPPs (but not IPPs) also allow the contributor to decide whether they wish this tax year's contributions to be made on a defined benefit or defined contribution basis, allowing them to manage their pension contributions to take account of their corporation's cash flow situation – and to better take advantage of broad market trends in the price of stocks and bonds.
One further benefit of using a PPP or IPP for one's pension is that fees are paid from pre-tax income so that the net after-tax cost of the fees is substantially lower than if using the conventional route of an RRSP. In many individual RRSPs, the fees are bundled within a management expense ratio that is deducted on a regular basis from the RRSP assets. While RRSP holders are often unaware of this leakage, since only the net asset value of the RRSP asset is showcased, it gradually erodes the growth potential of the fund. The combination of the lower after tax cost, and the ability to make extra contributions if the return from the underlying investments fails to meet the 7.5 percent hurdle makes PPPs and IPPs an unbeatable choice for individuals whose tax rates are above 35 percent.
Furthermore, PPPs can hold a much wider range of assets within their structure. The permitted list of assets includes not merely cash, bonds and equities, or mutual funds investing in these asset classes, but also non-correlated assets such as private equity, physical real estate such as the office building in which the corporation is based, mortgages, franchises and numerous other unlisted investments. As opposed to handing over the investment of one's pension moneys to a professional asset manager, contributors to PPPs can select individual assets such as buildings, franchises or mortgages of which they have personal knowledge, reducing what is known as “agency risk”, where the manager is investing other people’s money and may not always exercise as much care or diligence as would be the case if there was a personal involvement.
In summary, today’s challenging investment environment can be turned into a competitive advantage, from a savings point of view, thanks to the specific tax structure of the personal pension plan.