In fact, the most important decision to be made is, as per the famous paper published in 1986 in the Financial Analysts Journal by Brinson, Hood and Beebower, asset allocation. Brinson et al studied the performance of 91 large US pension funds between 1974 and 1983 and concluded that on average asset allocation accounted for more than 90 per cent of a given portfolio's return. Asset allocation is simply how much of your portfolio to invest in bonds versus shares and property; that is, the split between relatively safe, lower-return investments and higher-risk, higher-return investments.
While the average New Zealand pension fund has favoured a reasonably stable asset allocation of roughly 40 per cent in bonds and 60 per cent in property and shares for the past 30 years or so, the distribution between asset classes can vary widely by adviser.
If your adviser is a stockbroker, owns a racehorse and a Porsche, expect to have lots of shares in your portfolio. But if your adviser survived the 1987 crash and the subsequent investment doldrums for the next four years, he or she may have a more healthy regard for bonds.
A cynic might also suggest that the higher your adviser's annual fees, the less likely bonds will feature in his or her recommendations, although in today's environment, with regular doses of bad news coming from the US and Europe, it is a fair bet that bonds and cash deposits are foremost in the minds of many individuals.
Immediately after the finance company debenture and CDO mis-selling disasters, it wasn't obvious as to where the next debacle afflicting retail investment portfolios would come from, particularly given the fact that many of the worst advisers had retired prematurely.
Today, however, with Wall St down 2.5 per cent in US dollar terms in the year to date, the impact of poor advice is becoming clearer - anecdotal evidence suggests that most retail portfolios managed for a fee by financial advisers and stockbrokers are underweight bonds with the prevailing view being that "interest rates are going up locally" and "are too low overseas".
This view, combined with the fact that annual fees dictate the need for higher returns, has meant that many portfolios are grossly overweight equities and underweight bonds relative to the benchmark 40 per cent weighting typically held by the average pension fund.
This will mean that, in the current bear market for equities, retail investor portfolios will fall by more than they should and, if the recession deepens, as 10-year US treasury yields suggest it will, dividends will come under pressure and investment income from portfolios will be reduced.
However, there is independent advice out there if one cares to look. Just last month the OECD published its annual Pension Markets in Focus paper, which gives some useful insight into what constitutes best practice among institutional investors around the world.
The OECD paper sets out how institutional investors have addressed the asset allocation decision. "In most of the OECD countries bonds, not shares, remain by far the dominant asset class accounting for 50 per cent of assets on average," the paper noted.
However, looking at the data there is quite a large divergence on what is the appropriate split between bonds and shares with the world's largest pension market, that of the US, opting for a 50 per cent weighting in shares and just 25 per cent in bonds and cash.
At the other end of the spectrum German pension funds have a particularly conservative profile with less than 10 per cent in shares, 45 per cent in bonds and cash and a further 29 per cent in other fixed-interest investments.
The paper also commented that most pension funds use a "rebalancing strategy" whereby they buy shares and sell bonds in times of falling share prices to keep their weightings at targeted levels.
This strategy makes some sense for retail investors. But we need to remember that transaction costs are much lower for institutions than for Mum and Dad.
Another interesting fact in the OECD paper was the size of various OECD countries' pension funds relative to the size of their economy. New Zealand's pension funds at 13.8 per cent of GDP were at the low end of the spectrum and on par with those of Mexico, Hungary and Portugal. In comparison, US pension fund assets represent 73 per cent of the output of the US economy, and the OECD average is 72 per cent.
This perhaps illustrates the extent to which New Zealanders have opted for residential property investment over savings via pension funds, but also no doubt reflects the large tax advantages Americans and others can get by saving via a pension fund.
The other interesting piece of information for retail investors was a section on the operating costs of pension funds as a percentage of total assets. New Zealand pension fund costs at 0.7 per cent a year of total assets were more than double those of Canada, at 0.27 per cent, so it looks like pensions are more expensive in New Zealand than other countries.
However, at 0.7 per cent pensions as an investment option look good value compared with the bespoke financial planning service from financial advisers and stockbrokers, where annual fees are typically in the range of 2 to 3 per cent a year.
The OECD paper also looked at the performance and investment strategies of public pension reserve funds like the NZ Superannuation Fund and Australia's Future Fund.
In a global context the NZ Super Fund is a very small player with, as at December 31, 2010, US$11.2 billion ($13.1 billion) of assets. That compares to the US$65.8 billion of the Future Fund and US$2.6 trillion of the Social Security Trust Fund of the US.
In terms of relative performance, our Super Fund was the top-performing reserve fund in 2010, outperforming the average fund by about 8 per cent. However, in 2009 the Super Fund was the worst performer, underperforming the average fund by more than 20 per cent, according to OECD figures.
This relatively volatile performance can be explained if we compare the investment strategy of our Super Fund with that employed by other OECD countries. The NZ Super Fund has a relatively aggressive asset allocation, with just 9.2 per cent of its total assets in fixed-income assets and cash. This compares with the 100 per cent weighting in fixed-income assets and cash for the latest largest public pension reserve fund, that of the US.
Critics of the NZ Super Fund have in the past commented that because it is funded by the government and the government has borrowings, we are effectively borrowing money to invest in shares. This behaviour is generally regarded as high-risk and not recommended for individuals, as there is no "free lunch", in theory, because the additional returns from investing in shares via the Super Fund will be offset by higher risk.
On the other hand the Australian and Canadian public pension reserve funds, which are also effectively funded by debt, have modest weightings in fixed-interest, like our Super Fund, and lots of shares.
In the absence of one right answer, perhaps we should remember the two main sources of risk for diversified portfolios: inflation and deflation. So having a portfolio that includes a combination of bonds and shares will offer some protection against both.
* Brent Sheather is an Auckland stock broker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
