Article written by Kellands Hale our preferred independent advice firm.
This article is not intended to be financial advice to any individual. The views expressed are those of the author and Moneyfacts.co.uk does not endorse the content.
The UK phased in pension auto enrolment in October 2012 and this means many people will start accumulating pension benefits from the age of 22. Average life expectancy in 2021 for a 22 year old male is 86 years and for a female 89 years. This means that on average, people could be invested in a pension scheme for over 60 years.
Pension benefits can currently be accessed from age 55 although there are proposals to increase the minimum pension age to 57 in 2028.
In years gone by, Defined Benefit (DB) pensions were commonplace. DB (sometimes known as final salary) pensions provided a guaranteed level of income based on a pension scheme member’s salary and length of service. For various reasons, DB pension schemes are now rare in the private sector although accumulated DB benefits generally continue to increase in line with inflation in deferment.
Instead, most pension schemes are now defined contribution (DC) arrangements, where the level of benefits that these schemes provide varies based on a range of factors including the level of contributions, investment returns and charges, amongst others.
In a DB scheme, investment returns do not influence the benefits paid to members, but investment returns are paramount to the benefits payable from a DC scheme, therefore getting the investment strategy right is crucial.
A skilful financial adviser will create a comprehensive plan for their clients. The investment strategy will take into consideration their client’s objectives, attitude towards investment risk, how much they can afford to lose (sometimes referred to as capacity for loss) and how much risk the client needs to take in order to meet their objectives. They will also monitor investment performance and make changes accordingly as the compound effect of poorly performing investments will have a detrimental effect on pension benefits.
A 22-year-old who is many years away from taking pension benefits can normally afford to take more risk and so may allocate a larger proportion of their investment to higher risk assets e.g. equities (shares), commercial property and commodities.
Higher risk assets tend to be more volatile, which means prices tend to go up and down by a greater extent than lower risk assets. By making regular monthly contributions, savers can benefit from “pound cost averaging”, which is the concept of making regular contributions to investments in order to smooth out market volatility. By making regular contributions, pension scheme members naturally purchase fewer units when prices are high and more units when prices are low but the average purchasing price is smoothed.
As retirement approaches it is often prudent to begin to reduce the level of risk in the portfolio to protect the purchasing power of the pension fund. This can mean allocating more of the fund to cautious assets such as corporate and government bonds, which affectively involves lending your capital to those entities and receiving an interest payment in return. Returns from these asset classes will generally be lower but it’s important to adjust the investment strategy through the life stages and as circumstances and objectives evolve.
Time horizon is an important factor when deciding how much investment risk to take. The logic being that those with a longer period to retirement have sufficient time to allow the investment to recover should there be a market crash. Conversely those with a shorter time horizon have less time for their investments to recover.
A significant factor influencing the amount by which risk is reduced will be determined by how retirement benefits are to be taken. People looking for certainty may wish to purchase an annuity, which is where pension savings are given to an insurance company in return for a lifetime guaranteed income. In these circumstances the entire investment portfolio should be invested in cautious assets such as cash and government debt once retirement age is reached.
Due to increased life expectancy and record low interest rates, annuity rates – which determine the amount of income people receive in exchange for their pension savings - are currently deemed poor value for money by many.
This has made flexible access drawdown (FAD) a popular option in recent years, particularly since pension freedoms were introduced. Pension freedoms legislation means that it is no longer compulsory to purchase an annuity and there are no limits on how much can be withdrawn from the pension fund.
The FAD arrangement will generally remain invested for the rest of the scheme member’s life and many people will be retired for 20/30/40 years, which is why it is important to have a blend of assets that enable the investment to keep pace with inflation but also minimise downside risk so that income withdrawals are sustainable.
When making regular contributions in accumulation, volatility can be beneficial due to the aforementioned pound cost averaging but the opposite can be true when taking regular withdrawals from a pension fund. When taking withdrawals, sequence risk is a key consideration in determining an appropriate investment.
Sequence risk is the danger that the timing of withdrawals will damage the investor's overall return. Withdrawals when the fund value is lower are more costly than the same withdrawals when values are higher. Withdrawals from pensions tend to be for set monetary amounts so when values are down, the withdrawal equates to a higher proportion of the fund value and this can make the income less sustainable. A diversified investment strategy can protect the portfolio against sequence risk.
As pensions are an extremely long-term savings plan, there will inevitably be changes to taxation, economic conditions, pension legislation and personal circumstances, which is why it is important to ensure that the investment strategy is adapted accordingly along the way.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.