Why counterintuition might be a good thing in the pensions world.
Counterintuitive is one of my favourite words. My partner loves the word ‘disingenuous’ which I’m a bit jealous about as that sounds a whole lot smarter than ‘counterintuitive’ to me, but he’s claimed it as his. So, I’ll stick with ‘counterintuitive’.
What can spitfires teach us about pensions?
I read an interesting post today about scientists analysing the bullet holes left in Spitfires returning from their missions in WWII and using those bullet holes to suggest where additional armour plating should be added to the plane.
That makes a whole lot of sense to me, and probably to most people reading the same story. A lone scientist decided to voice a counterintuitive opinion; what if the bullet holes showed where the Spitfire could survive a direct hit, and the Spitfires who were hit in the other places didn’t return at all. Shouldn’t the armour plating be added to the parts of the returning planes without bullet holes?
I love that story. It shows that sometimes we should be open to conclusions that are the opposite of what instinctively feels right.
One of my friends mentioned in passing that they were thinking of reducing their pension contributions because their fund appeared to keep dropping, and what was the point in throwing good money after bad?
I’d like to suggest looking at things in a different way.
I know people’s pension funds have taken a beating over the last 12 months and we don’t know when things will improve.
I know that the cost-of-living crisis is hitting so many people hard and pension contributions can be an easy thing to reduce or stop right now.
I’m not suggesting for one second that anyone who is facing an affordability issue should do anything different (but please check out MoneyHelper to see if you have other options).
My message is for anyone who is lucky enough to afford paying their pension contributions and who still might have spare pennies right now.
Do you have spare cash for your pension?
For people in what we call defined contribution (aka ‘DC’ or ‘money purchase’) pensions, every contribution paid in for you will purchase units in the fund(s) you’re investing in.
The price of those units changes every day, based upon what’s happening in the market. The value of your fund is based upon the number of units you have bought and the price of those units.
So, when my friend said that their fund was going down, they meant that the price of every unit they held in the fund had gone down. I can understand why they were put off from maintaining or paying more contributions in, on the face of it.
Why the value of your pension going down isn’t always a bad thing!
Now, my friend isn’t close to retirement (say, within 5 years) and the fact that their fund has gone down isn’t as bad as it might seem.
The value of your fund is important if you’re closer to when you decide to do something with it and they’re not going to do anything with it for a while yet.
What if my friend stops focusing on the value of her fund and instead thinks about the fact that the prices they’re buying units at are lower than before? Doesn’t that mean they’re getting more bang for their buck? Well, yes it does.
How lower unit costs can give you more bang for your buck.
Think of it like this.
In July
your £100 pension contribution buys you 40 units in your fund because the price of each unit is £2.50. You have a total of 40 units.
In August
your £100 pension contribution buys you 45 units in your fund. This must mean the price of each unit is £2.22. You now have a total of 85 units and your fund value is (85 x £2.22) = £188.70. Sounds pants, right? I mean, you did pay in £200 to get that £188.70!
In September
the price of each unit in the fund dropped to £1.95. That meant that your £100 contribution purchased 51.28 units – you now have 136.33 units in the fund and your fund value is £265.75.
| Month | Contribution | Unit Price | Units Purchased |
|---|---|---|---|
| July | £100 | £2.50 | 40 |
| Augst | £100 | £2.22 | 45.05 |
| September | £100 | £1.95 | 51.28 |
| Total | 136.33 |
Again, this doesn’t sound great in exchange for a £300 investment but that’s only real money if you need it right now.
If unit prices rose back to just their starting point, they’d have a fund value of £340.83 rather than £300 if unit prices had remained static.
What does a higher unit cost mean?
The flip side is that if markets had been rising, the units your contributions were buying would have been more expensive, as shown below.
| Month | Contribution | Unit Price | Units Purchased |
|---|---|---|---|
| October | £100 | £2.50 | 40 |
| November | £100 | £2.65 | 37.74 |
| December | £100 | £2.90 | 34.48 |
| Total | 112.22 |
As you can see, the total number of units purchased over the last 3 months is much less than the 3 previous months when prices (and their fund value!) were lower.
My friend would have therefore seen more value for money from their contributions in the first 3 months.
In this example, if unit prices fell back to their starting point, they’d have a fund value of £280.55 rather than £300 if unit prices had remained static.
Pound cost averaging
The same principle applies in something referred to as ‘pound cost averaging’ (I prefer the term ‘drip feeding’).
Pound cost averaging is the principle that pension contributions paid over a year, rather than in one go as a single lump sum contribution, help protect you from volatile markets.
Pension contributions paid in this manner take away some of the stress if you’re trying to pay a contribution when you think the markets are lowest to get the best value from it, also known as ‘timing the market’.
Paying contributions regularly also creates a habit and good habits generally stand us in good stead in the long run. More than that, they help us see the volatility in a less frightening light.
Market volatility can be scary, but it’s part and parcel of investing so it’s better to understand how we might potentially benefit from it, rather than focus on the negative aspects.
Chris
