The benefits of automated pension plans

While many people will prefer to speak to fellow human beings when discussing their investments, automation is already part of everyday life. Over the last few years we have seen introduction of robo-advisors, with many pension investment companies placing these new platforms front and centre of their future strategies. So, what are the benefits of automated pension plans and robo-advisors?

No-nonsense information gathering

KYC, or Know Your Client, is an integral part of the investment world. The wider your knowledge base on a particular client the more personalised the service you can offer. Failure to gather the correct information, and use it accordingly, is a breach of investment regulations in many countries. Therefore, the use of robo-advisors allows a no-nonsense and clear approach to information gathering.

These systems use an algorithm to choose the most appropriate investment strategy for your pension fund. The algorithm is based upon issues such as:-

• Your attitude to risk
• Your investment term
• Your current investment goals

It is worth noting the variable “your current investment goals”. Due to the way that the system is set up, you can update your investment goals on a regular basis. This means that your portfolio would be automatically adapted to your new goals.

As pension-fund regulations continue to be tightened, information gathering is becoming even more important. This initial data gathering exercise will also incorporate a degree of guidance and thought provoking comments. For example, this could highlight the risk/return ratio and the suitability for pension fund investment. The concept of the robo-advisors platform is simple; participants have time to think about the consequences of their attitude to risk for example. The majority of platforms use a concept known as modern portfolio theory.

Source: Unsplash

What is modern portfolio theory?

As a sidenote, you will find that many robo-advisor platforms will mention the concept of modern portfolio theory. This is a Nobel Prize winning economic theory based on the use of data points to create a personalised portfolio of investments. Modern portfolio theory presumes that the majority of investors are risk averse. This means that those looking to take additional risk will expect additional rewards. As a consequence, their pension-fund portfolio would need to reflect this.

Using ETFs to create a personalised portfolio

Automated pension investment platforms (also known as robo investing) tend to use Exchange Traded Funds (ETFs) to create personalised investment portfolios. ETFs have been around for many years and they are an integral part of the investment scene. There are numerous benefits to using ETFs such as:-

Focus on a particular market/type of investment

ETFs are basically funds which are structured to mirror the make-up of a particular market, sector or type of investment such as a commodity or index. For example, the S&P/TSX Composite Index is recognised as the benchmark Canadian index. As a consequence, for those pension fund investors looking at a balanced risk/return, an ETF mirroring this index would be ideal for their portfolio. The funds are created by replicating components/weightings of a particular index with some ETFs also using futures and options

Continuous adjustments

Just as indices are rebalanced from time to time, it is important that your pension fund investments undertake the same process. Say for example the robo-advisor system created a personalised portfolio consisting of two index ETFs. If one index was to perform much better than the other, at some point this would need to be reweighted. The strategy behind this is simple; if the balance of your portfolio was tilted towards one particular ETF index then your future performance would also be tilted towards that index. This could lead to increased volatility and impact the balanced approach to investment.

Price visibility and trading

While many people view ETFs and mutual index tracking funds as one and the same, there are a number of differences. The main difference is liquidity, with ETFs constantly traded throughout the day and mutual fund prices set at the end of each trading day. As a consequence, robo-advisors can react to intra-day news flow, while those holding mutual funds will need to wait until the daily price has been set. You’ll often find that transaction costs associated with ETFs can be significantly less than mutual funds.

Risk profile criteria set by human experts

While the majority of the processes associated with automated pension plans have little or no human input, there is significant input with regard to risk profiles. This means that investment experts will allocate particular ETFs, and other exchange traded instruments such as futures, to various risk/reward profiles. When we talk of risk/reward in the context of pension investments, this does not indicate extreme risk – this isn’t advisable for long-term pension investments. Indeed, those pension advisors allocating funds to ETFs offering extreme risk/reward ratios may find themselves answering questions from the regulators.

In the modern era, there is nothing to stop the process of opening a pension fund, right through to management of investments, from being fully automated. Whether we move closer to this alignment in the future remains to be seen. However, in the meantime the vast majority of investors prefer an element of human expert involvement, even if just to oversee any potential discrepancies.

Low-costs improve long-term returns

The cost of any service or product comes down to the components. Traditional active pension fund investment will involve an array of different people with different skill sets. The combined cost of these teams can be significant and is reflected in the fund’s management and ongoing charges. Therefore, the more elements of the system which can be automated the lower the management fees and ongoing charges. When you also consider that many robo-advisors will use ETFs, which simply track various assets or indices, the cost element is yet another competitive edge.

While there is certainly a place for active investment management, using expert investment advisors, very often automated pension plans will complement this alternative approach. Many people now choose to maintain a core element of their pension fund under a robo-advisor platform, as their pension-fund backbone. Allocating an element to a more active investment approach offers the opportunity to enhance returns, although there is an obvious element of risk.

Source: Unsplash

Easy-to-use investment platforms

The subject of pension investment can be complicated at the best of times. Therefore, the introduction of robo-advisor platforms, offering regulatory updates and guidance, has been extremely useful for many people. A growing number of people seem to prefer this plain talking approach to pension fund investment. You could argue that this removes any potential conflict-of-interest, the volatility of human nature making way for cold hard facts. Obviously, there will be advice and guidance available, as and when required, but this would likely come at an additional cost.

It is worth noting that before any robo-advisors platform is released to the market it will undergo stringent testing. This testing will take in both in-person testing and remote user testing which is unmoderated. As a consequence, those creating these platforms can help and assist those testing the systems in person. On the flipside, remote user testing is akin to releasing the platform into the mass market. These users are guided by the instructions and design of the platforms, giving invaluable feedback on any tweaks and changes required.

Removing human emotion

The removal of human emotion from investment decisions can be considered something of a double-edged sword. However, robo-advisors provide a no nonsense approach to pension fund investment. A relatively swift in-depth questionnaire will gather all of the information required, allowing algorithms to calculate the appropriate risk/reward ratio. The use of EFTs takes away day-to-day management of investments, in favour of index tracking funds. Auto rebalancing and opportunities to adjust your risk/reward ratio going forward creates a very flexible environment.

Those looking for a passive investment strategy will be attracted to robo-advisors. Those looking for a more active approach still have plenty of choice in the wider market. Then there are those looking for a mix of the two. In recent years we have seen huge advances in artificial intelligence, which already play a role in wider investment trading strategies. Will this technology become more commonplace in the future?

Summary

Robo-advisors have been around, in some shape or form, for some time. In many ways they do the time-consuming legwork that human advisors did in the past. This allows pension advice companies to focus their funding on areas where they can enhance their business. There is a general misconception that robo-advisors have total control over pension fund investments. This is wrong. There are human advisors and investment experts in the background tweaking the system, allocating EFTs to specific risk profiles and constantly enhancing their offering. 

While the current raft of robo-advisors make little or no use of artificial intelligence, the ability to learn, this must surely be an aspiration for the future. This is an area of the market which is constantly developing and changing. We already accept artificial intelligence in many areas of our life, so why not the world of investment? Would you trust an advisor who was able to learn from human mistakes?

This is a Sponsored Feature.