Optimising a pension and knowing which fund to choose can feel like alchemy, so most people don’t bother. But, the difference could be tens of thousands of pounds in your pension fund when you retire.
It's not as complicated as it looks, as explained in various Grad Rag to Riches posts…let’s take a closer look.
By law, all employees are automatically enrolled in a company pension scheme unless they actively object. If you contribute, your employer has to contribute as well; free money from your employer on top of your salary!
Also by law, the scheme must have a default fund which you are invested in unless you make an alternative choice. If you join, but take no further interest, your money will be placed in the default investment fund and stay there; around 90-95% stick with the employer default fund, whether it suits them or not.
The default pension fund is chosen to fit the average staff member but is the equivalent of everyone being given a medium-sized t-shirt - one size will not fit all. Default funds tend to play safe because employers do not want to get blamed for costly mistakes that endanger their staff's pension savings. Therefore, most default funds tend to be balanced funds with a mix of equity and bonds, and possibly with some other assets thrown in for balance. These funds will then be lifestyled, which means the balance between equity and bonds will change over time as the employee get closer to retirement.
What should you do
When you joined your employer pension scheme you will probably have been sent details of your pension provider and contact details; if you can’t find them, contact your HR department.
Contact your pension provider and ask for details about the fund your money is being invested in and if it is lifestyled; ask for a list of available funds; and your chosen retirement date. Your retirement date will probably have been set to the state retirement age of 65-68, but you can set this yourself to any age from 55.
Do you want to be lifestyled
Lifestyling is the automated pension process of changing your investment strategy on your behalf as you age and approach your chosen retirement date. The idea is that the investment risk is reduced as you get closer to your retirement date by moving from equity to bonds so that you don’t suddenly lose a large value in a stock market crash just as you are about to retire. But this is very much a historic idea; back in the day when people retired at 65, you automatically cashed in a pension pot and bought an annuity, which effectively means that you give your pension pot to an annuity provider and they give you a monthly agreed income until the day you die. You cannot ask for your money back if you change your mind or circumstances change, and if you die soon after starting the annuity…tough!
Today you can keep your pension pot and withdraw from it tax efficiently whenever you want, to provide an income in retirement and stay invested to maximize your returns. So, if the stock market crashes 12 months before you wish to retire, it’s not great, but you can strategise to wait until the stock market bounces back before cashing in the equities (This is called the bucket strategy for decumulation).
This is why you may wish to turn lifestyling off and choose how to invest yourself; which brings us to the fund list and what to choose.
Which fund should you choose
Your pension provider will provide you with a list of alternative pension funds which largely look like they are described in gobbledygook; High growth fund, Targeted drawdown 2040 retirement, active low volatility equity…!
To get the lowdown on this investor speak, read Investing Terminology: Investing does seem complicated, but it doesn’t necessarily need to be!
The alternative choice to the default lifestyled fund will depend on your own personal circumstances such as your age, attitude to risk, or personal preferences. For example, younger savers with decades to go until they retire and access their pension should be prepared to take more risk than someone who expects to retire within a few years. Funds with higher exposure to equity have historically generated much higher returns over the long run than other investments such as bonds. But, as you get closer to your retirement date you may want to introduce some less volatile bonds to provide a cushion against stock market falls.
Look at the costs of the funds, as the higher the charge, the less money is available to compound for your future. If the fund charge is 1.5% compared to 0.5%, it doesn’t sound like a big deal….but it is! This could massively affect how much money you retire with. Look for funds with low charges in comparison to others – these will probably be index funds rather than managed funds.
Eventually, you are going to have to make a choice, and this is where lots of people stop due to fear of doing wrong. The thing is, no matter what, you are very unlikely to make a terrible choice. For a start most of the funds you finish off looking at will be very similar – equity, a mix of bonds and equity, and maybe some alternative assets like property.
If you have decided on a risk level you are happy with (100 equity, 60/40 equity/bonds, etc), you can always change it at a later date. If you have a long way to go to retirement but don’t feel comfortable all-in equity at the start, so be it. You are being intentional in your strategy; by going through this process you now have knowledge and understanding of what you are doing. Over time, by keeping involved and planning ahead, you may change your strategy as you go forward. Review your pension annually.
If you are struggling to choose between two or three funds….then choose them all. Monitor their performance going forward and see how they stack up against each other. This would also be a great learning experience. But, try not to have too many funds as this would become over complicated.
What John did
When John graduated and joined XYZ Ltd, he was automatically enrolled in his company pension scheme with the following benefits:
• Retirement benefits linked to the contributions paid by you and XYZ Ltd and the investment returns received on those contributions.
• Lump sum death benefit of six times basic salary, if you die in service with XYZ Ltd and whilst a contributing member of the Plan.
• Ill health benefit cover of 50% of basic salary, which will be paid for up to five years if unable to work due to ill health.
John was enrolled to automatically pay from his gross salary the amount of 4%, which means for every £1000 he earns, £40 automatically goes into his pension fund before tax and before any money is paid into his bank account.
XYZ Ltd also agrees to automatically pay into his pension at the same time 6% of salary, which means that for every £1000 John earns, the company gives him an extra £60 for free!
So, if John is earning £30,000 per year, he is also automatically contributing £3,000 per year to his pension.
John has also been given the option to pay an additional 1% or 2%, and XYZ Ltd will match the contributions (more free money!); If John pays the additional 2%, with XYZ Ltd matching, this equates to a further £40 for every £1000 earned.
Assuming John is 25 and plans to retire at 65, with no change to salary over the years (unlikely!), and the fund returning a linear 6% after costs, John could have a pot of cash at retirement close to £500k. If John decides to take advantage of the extra matched contribution, this pot of cash would then reach nearly £700k. The power of Compound Interest!
John is currently in the default fund 'The Growth Blend Lifestyle Strategy Fund' which is investing in equities, bonds, and other assets such as property. The asset split is approximately Equity 60%, Bonds 30%, Property + other 10%. As we said earlier, a one size fits all fund.
Eight years from the selected retirement age (which John has not selected, so has defaulted to 68), the fund gradually switches into less volatile investments to “reduce exposure to risk over time”. The annual fund charge is 0.17%, which is pretty good.
John has a range of funds to choose from, but he has not looked at this yet; the investment choices he makes now will directly affect how much money will be in his pension at retirement.
As we know from past Grad Rags to Riches blogs, different investments carry different levels of risk in the form of volatility, and different potential for growth. It is important to strike the right balance. More volatile equity will probably provide better returns over the longer term, BUT, over the shorter term, the value of the pension could go down, leaving less than was paid in. Bonds provide a more cautious approach to investing and should not be as volatile, therefore less risk that the pension could go down in value, but, a risk that the value will not keep up with inflation.
John plans to retire at the age of 55. Therefore, with a 30-year time horizon, he decides to invest 100% in a low cost global equity index (or passive) fund for at least the next 20 years.
John’s pension provider does not charge for switching funds and having read through the pension provider fund list, he has settled on 'The Passive Global Equity Fund' with a total annual fund charge of just 0.154%. The fund is described:
This aims to seek long term growth of capital and income. It will seek to achieve this by investing predominantly in global equity and equity related securities that, as far as possible and practicable, reflect the component global equity securities of the MSCI World Index (Net Dividends Reinvested) Index.
The individual fund factsheet gives more detail like the asset breakdown (which can be seen at the top of the page).
Job Done! Sit back, turn your chair away from the desk, and enjoy the view from your window! John has set himself on the path to financial success and future wealth. Don’t procrastinate; draft your financial plan with the help of Grad Rags to Riches!
Saving into a workplace pension is a sensible way of growing your longer-term finances, but if you are contributing at the minimum level, it might not necessarily be sufficient to fund the retirement you desire. Don’t leave it to chance; make sure you have a financial plan and have calculated how much you want to retire with to be financially independent.