Key things to consider when building up a pot of money for later life
Thursday 23 Sep 2021 Author: Tom Selby

If you’ve decided to invest in a pension – either via your workplace or in a personal pension like a SIPP – you might need to think about how you’d like your money invested.

In this article we run through some of the key points to consider.

I HAVE A DEFINED BENEFIT PENSION. HOW DOES THAT WORK?

If you are a member of a funded defined benefit pension, where your retirement income is guaranteed and based on the number of years you have worked for your employer, you won’t have to make any investment decisions.

Instead, trustees will invest the scheme’s collective assets on your behalf. The employer will be required to pay your pension regardless of how these underlying investments perform, with the Pension Protection Fund (PPF) acting as a lifeboat scheme should the employer sponsor fail.

Members of unfunded public sector defined benefit schemes, which includes people like teachers and NHS workers, have their pensions paid from general taxation. This means contributions are not invested in real assets, with the state effectively guaranteeing to pay your retirement income.

I HAVE A PRIVATE PENSION. DO I MAKE THE INVESTMENT DECISIONS?

If you’re saving in a private pension, you will need to decide how much risk to take with your money. In general, the higher the risk, the more volatility you will experience in your investments.

Investing in companies tends to come with more risk, but also more opportunity for long-term growth. Things like government bonds, on the other hand, are usually safer but offer less by the way of upside.

HOW MUCH RISK SHOULD I TAKE?

You also need to consider the impact inflation might have on the value of your investments. If you invest in safer assets like government bonds your money should grow predictably but at a relatively low rate – and this could be chipped away at by rising prices.

For example, if your investments deliver 2% annual returns and inflation runs at 3%, in reality the value of your investments – or how far your money will go – will have fallen by 1%.

This is one of the main reasons most people will want to take at least some risk when investing their retirement pot during their working life. Traditionally younger savers can afford to take a bit more risk as they have decades to ride out the ups and downs of the stock market and, in theory, benefit from compound growth.

However, deciding how much or how little risk to take is a personal decision, and will depend not just on your time horizon but your preferences, financial situation and long-term goals. Whatever level of risk you plump for, it’s vital you diversify your investments around different assets and different regions of the world.

WHAT IS DIVERSIFICATION?

Diversification is simply a way of investing that ensures all your eggs aren’t in one basket. If you chose to invest your entire pension in a single company, for example, then your retirement would hinge on whether that company is successful or not.

Similarly, if you only invest in US technology firms then the success or failure of this sector will go a long way to determining your lifestyle in older age.

Most people aren’t comfortable with having so much risk in one company or area, particularly as it’s likely to lead to extreme volatility. Instead, it’s usually preferable to invest your retirement pot in a range of different assets in countries around the world.

THAT SOUNDS A BIT COMPLICATED – ARE THERE ANY SHORTCUTS?

It is possible to build your own diversified portfolio of individual shares and bonds, but this requires you to dedicate a lot of time to researching companies, combing through balance sheets and assessing their short and long-term value.

For those who prefer not to take on this level of work – which is most people – there are funds available which aim to do this for you. In return for the fund manager taking on the legwork you’ll need to pay them a fee.

So-called ‘multi-asset’ funds are increasingly a feature of the UK market, potentially allowing savers to hold a diversified portfolio in a single investment. These funds are often targeted at different risk appetites, ranging from low to high (although they might have slightly different labels).

When picking any fund, you need to keep your costs and charges as low as you possibly can, as these costs will eat away at your returns.

WHAT DOES ‘DEFAULT FUND’ MEAN ON A WORKPLACE PENSION AND IS IT RIGHT FOR ME?

If you are employed, aged 21 or over and earning more than £10,000 you will be automatically enrolled into a workplace pension scheme. This scheme will be chosen by your employer on your behalf.

Some schemes may offer you a wide choice of investment funds, while others will be more limited. However, by law every auto-enrolment scheme has to offer a default fund, and this is where your pension will be invested if you don’t do anything.

Fund charges for default funds are capped at 0.75%, although many will charge less than this. Each default fund will hold a slightly different mix of assets, but crucially this will be designed based on the broad membership rather than your own personal circumstances.

You may want to choose other investments from your existing scheme that better match your age, risk profile and preferences – or even transfer your auto-enrolment funds to a different provider altogether.

Both options are possible under existing rules, although you will be moving money from a charge capped environment to one where charges are not capped.

SHOULD I ‘DE-RISK’ MY INVESTMENTS AS I APPROACH MY CHOSEN RETIREMENT DATE?

When people talk about ‘de-risking’, this just means shifting your investments out of higher risk assets such as equities and moving them into safer assets like bonds and cash.

This was traditionally the approach taken before the pension flexibilities were introduced in April 2015.

Prior to April 2015, most people used their retirement pot to buy an annuity, and so moving to safe assets in the years before this happened made sense to build certainty into their plans.

If you are still planning to buy an annuity or cash out your entire pension pot, de-risking in this way could still make sense.

However, someone planning to stay invested while taking an income in retirement through drawdown might have decades left in the markets.

As such, while taking an income from your pension might lead to a review of your strategy – and possibly a shift towards income-producing investments – your asset allocation may not materially need to change at this point.

WHAT ELSE SHOULD I THINK ABOUT WHEN INVESTING AND TAKING A RETIREMENT INCOME?

Wherever you choose to invest your retirement pot, when building your savings and taking an income it is crucial you keep your costs and charges as low as possible, as even small differences can have a big impact.

You should also consider the impact significant drops in the value of your investments over the short-term might have on the sustainability of your withdrawal plan.

 As a very rough rule of thumb, a healthy 65-year-old should be able to withdraw somewhere in the region of 3% to 4% of their starting pot value as an inflation-adjusted income and be confident the fund will last the distance. However, the rate that is sustainable for each person will depend on the performance of their investments and personal circumstances.

You should also consider the investments you choose to generate that retirement income. Investments that pay healthy dividends are popular among people generating an income through drawdown, allowing you to preserve your underlying capital.

A natural yield strategy – where you simply live off the income your investments generate – is one way to make sure your pot stretches longer, or you have more to leave to loved ones after you die. However, this can leave you open to big fluctuations in your income if dividends dry up, as we saw in 2020.

Taking taxable income will trigger the Money Purchase Annual Allowance, reducing the amount you can contribute to a pension each year from £40,000 to £4,000. If you are planning on making pension contributions larger than £4,000, consider accessing your pension later in life or just taking some of your tax-free cash.

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