The word ‘pension’ is enough to make most people’s eyes glaze over. In our experience, this is largely due to a lack of understanding and confidence in how they work, and, more importantly, what they mean for you. Over our next three blogs, we will shed light on three key areas where people often struggle, starting with arguably the most important – investment choice.
A brief history
Before diving into how your pension savings are invested, it is important to first understand how they work and how we got to where we are today.
In summary, a pension is a long-term savings vehicle designed to provide financial security in later life. Its key benefits include:
- Tax relief on contributions
- Tax-free growth of the underlying investments
- Additional employer contributions which workplace pensions benefit from
The funds can then be accessed once you reach the minimum pension age, which is currently 55.
Pension freedoms
One of the most significant changes to pensions was in 2014, when the then-chancellor, George Osborne, announced the Pension Freedoms Act.
This provided individuals with the flexibility to draw on their pension savings as and when they needed, either by taking a lump sum, regular income, or a combination of the two. This meant they no longer needed to cash in their entire pension or purchase an annuity.
For the families we look after, this flexibility is invaluable, particularly in a time where traditional retirement is becoming less common, and pensions are used as a tool to bridge income gaps.
While greater choice was a positive development, it also increased the risk of poor decision-making, which highlights the importance of actively reviewing pension investments to ensure they are appropriate for you.
Default funds: the passive approach
When joining your workplace pension, contributions are typically invested into the default investment position, which are designed as a one-size-fits-all solution. This gives no consideration towards your investment timeframe or how you intend on accessing your savings, which are two of the most important considerations when it comes to investing.
Even though default funds provide diversification by spreading risk across hundreds or even thousands of companies, they also come with limitations. One of the most common feature is lifestyling or target date strategies, which gradually shift investments into lower-risk assets as you approach the nominated age that the scheme assumes you will access the savings.
Whilst this approach may seem logical, there are a few drawbacks.
The risks of lifestyling
Lifestyling operates by automatically assigning a ‘retirement age’ when you initially join the scheme, which again, no consideration given towards your plans of when you might step away from work and access these savings. The investments then work towards this point, investing into ‘higher risk’ assets in the early years and shifting into ‘lower risk’ asset classes often ten years before retirement, but also as early as 15 years.
The phrase ‘lower risk’ should be read with caution, because these asset classes, such as government bonds and cash, are far from risk free:
- Government bonds: typically seen as safe, but recent volatility in the bond market, driven by rising interest rates and Liz Truss’ mini budget, proved otherwise. Those individuals who had their pensions unknowingly invested in ‘lower risk’ gilts saw their fund values drop by as much as 20%, with very little opportunity for future growth.
- Cash: similarly, with inflation soaring, the value of cash in a pension is being rapidly eroded. Retirees relying on pension withdrawals may find their savings depleting much faster than anticipated.
The risk here is not just potential losses but also missed opportunities for future growth. We find that the majority of people are unaware that their pension savings are invested with a ‘lifestyling’ or ‘target date’ strategy applied, which do not align with their actual retirement plans, often leading to reduced pension income in later years.
Our approach
From our experience, we find it is crucial that your pension is invested in a way that aligns with how and when you want to access it. For most, this involves withdrawing funds slowly and in stages. In this case, maintaining exposure to growth assets such as equities becomes essential to outpace inflation and sustain long-term withdrawals.
Unfortunately, many workplace schemes aren’t set up in a way to support this. Reviewing pension investments and ensuring they align with long-term goals can make a significant difference to retirement outcomes.
While pensions may seem complex, investing within them can be straightforward. The right strategy balances growth, risk management, and flexibility, ensuring savings work efficiently throughout retirement.