How to Diversify the Pension Funds during a Bear Market?

Retirement is the time when most individuals cannot afford to take a lot of risks anymore. Most people discontinue working after retirement and do not have a steady source of income, except pension. Therefore, it is crucial to diversify pension funds and hedge all the possible risks. Pension diversification is a key tool to ensure that you have stable and secure funds post-retirement, and your portfolio is robust.

What is Pension Diversification?

Pension diversification implies that the pension funds are well invested in a variety of geographies, currencies, industries, and asset classes to create an optimized portfolio. The risk-return profile of a diversified pension portfolio is balanced and ensures uninterrupted post-retirement income. It secures the financial status of individuals despite economic conditions, market levels, and geopolitical circumstances.

Constituents of Pension Diversification

The diversification of pension funds includes investing the funds in international markets in addition to the home country, a variety of asset types, and variable risk profiles. The ultimate objective is to avoid overlapping of risks and creating a pension fund that can weather unforeseen and challenging macroeconomic situations.

• Geographical Diversification: When a crisis hits, all countries are not equally impacted. Therefore, it is essential to diversify pension funds across different countries and regions. A higher allocation of funds to the home country is quite intuitive; however, it is crucial to undertake global diversification and not put all the eggs in one basket. Through geographical diversification of pension funds, you can reduce your exposure to political and economic risks and increase the returns. Additionally, since different countries experience different business cycles, investment cycles, and rules and regulations, gains in one region may compensate for losses in the other.

• Industry Diversification: Similar to hedging risks across different geographies, you can also diversify the pension fund’s portfolio by investing in a variety of industries. For instance, the factors affecting the performance of the finance industry and the healthcare industry differ from one another and may not come into action at the same time. Therefore, if specific legislation poorly affects the performance of the finance industry, the same can be compensated by the not-so-poor performance of the healthcare industry. Different sectors follow different economic cycles, technological breakthroughs, and government policies, and are suitable for hedging risks.

• Asset Type Diversification: Asset types form a significant part of pension diversification. The pension funds can be invested in a wide variety of financial instruments, including stocks, bonds, commodities, real estate, futures, and cash and cash equivalents. The choice of asset type is based on the risk tolerance of the investor, his age, financial status, and several other factors. For instance, the pension portfolio at a younger age may have more exposure to equities as they generate higher returns; however, due to the high-risk profile of stocks, fund allocation to equities should reduce as the person approaches the retirement age. Additionally, funds can also be diversified into alternative asset types, like cryptocurrencies, art, and private equity, as they have a very low correlation with the traditional investment vehicles.

Benefits of Diversifying the Pension Portfolio

The significance of pension diversification has become more prominent during the current difficult times. The potential global financial crisis of the present comes as a reminder that risks can never be eliminated. However, they can be reduced and spread by using effective diversification strategies. Diversification has become the key watchword for the entire industry.

• Avoids Financial Disasters: Retirement is the time when people don’t want to and can’t run around taking care of their finances. This is the reason you invest in pension funds and hope for financial stability post-retirement. However, if the pension portfolio is not safe and highly risky, the entire premise of pension becomes questionable. The diversification of the pension portfolio ensures that retirees avoid financial downturns and save themselves from disastrous economic conditions like the one we are facing at the moment.

• Minimizes Risks and Maximizes Returns: The economic disasters of the current scale do not happen very often; however, no country, industry, or asset type is immune to risks. Even during normal financial conditions, several legislations, geopolitical changes, and other factors may upturn an entire region, country, or sector. Pension diversification serves to hedge risks and spreads them across, such that no single bad event can wipe off your entire investment. At the same time, diversification also helps to deliver strong and consistent returns on investments. Statistics have proved that it is nearly impossible to generate positive returns by investing in a single region, industry, or asset type.

Therefore, diversification of pension funds is all the more critical during a bear market. Additionally, most of the pension schemes have now transitioned to being defined contributions schemes. The retirement income is not predetermined in the defined contributions schemes, and the retirees have to ensure that the investment is safe and sound to generate enough returns throughout their lives post-retirement. This is as opposed to the traditional defined benefits schemes that guaranteed a specific retirement income, irrespective of the returns on investments.

Bottom Line

Pension diversification is as personal a decision as pension management. The target income, age of retirement, expected lifestyle post-retirement, health conditions, retirement goals, and risk tolerance vary from individual to individual. A healthier, less risk-averse, and more financially stable retiree may want to allocate more funds to stocks than to fixed-income securities. At the same time, another may consider alternative investments as more suitable for him.
Therefore, global pension diversification must also be customized based on individual needs. It is not recommended to leave the diversification decisions solely in the hands of the pension providers. Rather, you should make informed decisions and participate in the process of diversifying your pension funds to maintain a steady and regular income, even during bear markets.