The need to consider strategies that have limited exposure or low correlation to the investor’s industry.
If you ask typical plan participants what their single largest retirement asset is, they will probably provide you with a list of assets ranked by their perceived value in descending order. They might include their defined benefit (DB) plan, their RRSP, perhaps a home, and then work their way down the list.
Somewhat surprisingly, their single largest asset—the asset that can most meaningfully impact their level of wealth, short of inheritance—is usually left off the list. The net present value of participants’ income right up until the moment they retire is this critical component of retirement wealth. The greater the number of years between now and their retirement date, the more relevant this unsung asset will be.
Specialization and Concentration
In this era of specialization in the workforce, plan sponsors, consultants and the individuals themselves need to consider their industry concentration levels within the context of their entire portfolios.
In spite of the fact that the number of jobs that employees will have by the time they reach retirement is rising, most of these jobs will be in the same industry. This specialization introduces specific risk to the portfolio, as an individual’s ability to earn wages will rise and fall with the economic viability of their particular industry.
Many employees are also individual investors and, in that role, bring more industry-specific risk to their personal portfolios.
The growth of the DC market, in which employees manage their own investment processes, has introduced another means for employees to inadvertently increase their exposure to the industry in which they work. Many employees are most comfortable buying stock in companies that produce goods and services they understand well, ultimately compounding their lack of diversification.
Unintended Industry-specific Risk in Abundance
To illustrate how pervasive this issue can quickly become, envision a young employee in the technology sector whose compensation generally rises and falls with the performance of the industry. Now consider the correlation between the employee’s compensation and the performance of the technology sector over the next 25 years. You can see how this young employee’s fortune is closely aligned with the industry in which he or she works.
As the employee’s career progresses, his or her ability to buy individual securities is likely another means of investing for retirement. The employee, believing that he or she has an information edge in technology, builds a portfolio of securities heavily concentrated in this sector.
During the middle and latter stages of a career, this employee is likely to receive a higher percentage of compensation in company stock and options. While the employer views this as a strategic decision to align the employee’s interests with the company’s performance, it also amplifies the industry-specific risk in the individual’s retirement portfolio.
Solving the Diversification Dilemma
As with most problems in finance, it is often easier to grasp a problem than to develop a solution.
Working closely with plan sponsors and consultants, investment managers can develop solutions that identify industries with low correlations to the overexposed one and build portfolios that help to mitigate industry concentration.
Many employees face distinct risks depending on the industry in which they work and where they are in their savings lifecycle. As a result, managers are continually developing unique solutions with the goal of helping investors achieve financial security.
Diane Garnick is an investment strategist, Invesco Distribution U.S., Invesco Trimark.
> click here for a PDF version of this article and all of the other 2009 DC Summit articles.
© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the April 2009 edition of BENEFITS CANADA magazine.