Question

Essay question You run a pension fund and know that in 20 years' time you need to make a lot of payments to people who will then have retired. Should you: (a) invest in bonds that mature in 20 years' time so you know exactly how much you will then have, (b) invest in equities because historically their average return has been greater than bonds in the long run, or (c) begin mainly in equities but switch gradually into bonds as the 20 -year period elapses ?

Short answer

Option (c) is advised to balance risk and return over time.

Step-by-step solution

Understanding the Objective

The main goal is to ensure the fund can cover future liabilities in 20 years when payments to retirees are due. This involves balancing risk with returns to meet or exceed the fund's obligations.

Analyzing Option (a) - Bonds

Investing in bonds that mature in 20 years provides certainty about the future amount, minimizing risk since bonds have a fixed return. However, the potential returns might be lower compared to equities, especially if inflation is higher than expected.

Analyzing Option (b) - Equities

Investing in equities can potentially offer higher returns over a 20-year period due to their historical performance. However, equities are more volatile and may pose a greater risk of not having enough funds due to market fluctuations.

Analyzing Option (c) - Mixed Strategy

Starting with equities might capture higher growth potential, while gradually switching to bonds can reduce risk as the payout time approaches. This strategy seeks to balance risk and reward, ensuring fund growth initially and stability closer to the payout period.

Recommendation Considering Risk and Return

Option (c) is recommended as it allows capturing growth potential initially with equities and reduces risk over time by shifting to bonds. This approach offers a balanced path between potentially higher returns and financial certainty.

Key concepts

Bonds

When thinking about investments, bonds are often considered the safest option. Bonds are a type of fixed-income investment. They work like loans to the government or corporations, from which you earn interest over time. In the context of a pension fund, investing in bonds that mature around the time payouts are needed offers a significant advantage. This is because bonds provide predictable returns, meaning you know in advance how much you'll have when the bonds mature.
This predictability is crucial when planning for the specific financial needs of retirees. However, one significant risk with bonds is inflation. Over the years, high inflation can erode the purchasing power of the fixed returns that bonds offer. Additionally, in a climate of rising interest rates, new bonds may offer higher returns than older ones, leading to a decrease in the current bonds' market value. Thus, while bonds are safe, it's essential to weigh these factors against their safety and decide if they're the right tool for achieving pension fund goals.

• Predictable returns with known payout at maturity
• Safe but susceptible to inflation risk
• Interest rate influences market value

Equities

Equities, or stocks, are a form of investment that represents partial ownership in a company. Historically, equities have outperformed bonds in terms of returns, making them attractive for long-term growth strategies. Investing in equities for a pension fund can potentially increase the fund's value significantly over a 20-year period. This is largely due to the compounding effect of reinvested dividends and long-term capital growth. However, equities are more volatile than bonds. They are subject to market fluctuations, which can sometimes cause significant short-term losses. For a pension fund with a defined payout date, the risk is not meeting financial obligations when the market performs poorly.
Therefore, investing in equities is a robust strategy for early stages of the investment period but requires careful management and eventual risk mitigation as the payout period approaches.

• Potentially higher returns than bonds
• Volatile and influenced by market trends
• Important to shift strategy as payouts near

Risk and Return

The concepts of risk and return are fundamental to investment strategies, particularly for pension funds. Every investment carries some level of risk, generally associated with the possibility of losing money or not reaching financial goals. In general, higher risk investments, like equities, offer higher potential returns. On the other hand, safer options like bonds offer lower returns. For a pension fund that has both growth needs and stability requirements, managing the balance between risk and return is crucial. One strategy is to initially invest in higher-risk equities to leverage their growth potential over time, but gradually move towards bonds as the need for certainty and stability increases closer to the payout period. This is known as a life-cycle or glide-path strategy.
It's all about aligning the fund's risk profile with its financial obligations and cash flow timeline. Regular evaluation and adjustment of the investment mix ensure that the strategy remains effective in all market conditions.

• Balancing growth and stability needs
• Adjusting investment strategy over time is crucial
• Alignment with obligations ensures optimal performance