Updated 03 September 2020
Many more of us are saving into workplace pensions – good! Very few of us take any further interest in those pensions – bad! By not looking more carefully at how your pension is invested, you could be missing out on tens or even hundreds of thousands of pounds in retirement. Article by Nick Green.
If you’re employed in the UK (as opposed to self-employed) then you’re now entitled to a workplace pension. You’ll be enrolled automatically in your employer’s pension scheme unless you choose to opt out (see here for reasons you might do this). But although auto-enrolment is a good thing, it’s not an excuse to sit back and take no further interest in your pension.
Ignoring a pension could result in slower growth, too much risk, a mismatch with your retirement plans or even – in some cases – you forgetting about the pension entirely and losing track of it. So how do you become a more active pension saver?
As a minimum, you should take note of the kind of pension you have. There are two main types and they are very different: defined benefit (DB) and defined contribution (DC).
A DB pension (also known as ‘final salary’) pays you a guaranteed income from a certain age until the end of your life. Because of this guarantee, they have been traditionally very desirable, although the downside is that you cannot access the main pension pot (because there isn’t one) unless you transfer out.
Another potential downside of DB schemes is that they are costly for employers to run, and may run up deficits. This means that in theory it is possible that members may not receive their full guaranteed benefits, although the Pension Protection Fund exists to prevent members losing out. The chances of you losing out on any DB benefits are very small, even if your employer goes insolvent – but it is still theoretically possible.
A DC pension (also known as ‘money purchase’) on the other hand, is a pot of savings built up over time from contributions you make (sometimes with additional contributions from your employer). These savings are invested in a fund of assets (e.g. equities and bonds) so that they grow over time.
It is this aspect of pension saving – the actual investment of your money – that most people ignore entirely. But there’s a very good reason to pay a lot more attention to it.
By necessity, most DC workplace pension schemes have to be ‘one size fits all’. They must be broadly suitable for everyone who works for that company, be they a director or a junior recruit. Clearly, this isn’t really feasible – if the junior recruit and the director were to take independent financial advice on setting up their own personal pensions, they would end up with very different arrangements based on their income levels, life goals, attitude to risk and a host of other factors. So any workplace pension scheme that tries to accommodate them both will need to be extremely broad in scope.
Recognising this, most schemes do in fact include more flexible options so that employees can exercise more control. However, if people don’t choose to take an active interest (and most don’t) then their money will simply be invested in the default pension fund.
Your workplace pension scheme’s default fund will be as described above: a portfolio of investments that tries to suit the needs of all members as far as practicable. In short, it will probably be a fairly blunt instrument – satisfactory for everyone perhaps, but ideal for very few. Yet nearly nine out of 10 people in workplace DC pensions remain in the default fund, a statistic which makes it even harder for schemes to tailor the fund to people’s individual needs.
You might think, therefore, that all such default funds were very similar in makeup. However, research by the Punter Southall Aspire pension consultancy has revealed huge variations between workplace pension default funds. Their study found a whole range of different approaches in terms of structure, risk level and goals, which in turn ‘presents a risk for pension savers’, according to the consultancy’s chief executive, Steve Butler.
This variation between different default pension funds is largely a good thing, in that it allows employers to make a meaningful choice about the best scheme to offer their employees. But it does highlight the foolishness of accepting your employer’s default fund just because it’s the default. Every time you join a new employer’s default fund, you are blindly accepting someone else’s financial plan for you – a plan made entirely without your input or any knowledge of your circumstances. Add to this the knowledge that no default fund can suit everyone, and it becomes clear how important it is to find out what is being done with your money.
But can the choice of pension fund really that big a difference? Yes, it can. A 2015 study by JLT Employee Benefits found that the performance of the top 10 default funds ranged from around 3.5 per cent to 9.5 per cent from 2012 to 2015. Stretched over the course of a career, a difference of 6 per cent difference could translate into huge amounts of money.
For example, someone on an average salary of £35,000 saving seven per cent of their annual income would build up a pension pot of around £166,000 over 35 years, based on the lowest-performing default fund in the study. But based on the highest-performing fund, the same person could theoretically build a pension of around £670,000 – a difference of more than half a million pounds.
A word of caution here: the JLT study cited above covered only a very short time period, and it is highly questionable whether that 6 per cent difference between funds would be sustained over several decades. There are also many other factors to consider beyond mere performance. The first is the level of risk involved – a fund that can show rapid growth may also suffer heavy short-term losses, so consider how comfortable you are with this. Another is the way the fund is managed – an actively managed fund may ride the market better, but will probably involve higher fees, whereas a passive fund will be cheaper but potentially less resilient to the economic weather. You also need to consider the fund’s pre-retirement investment strategy. Some funds will move your money into low-risk assets as you near retirement, in preparation for you buying an annuity. However, if you don’t intend to buy an annuity at first (or ever) then this strategy can potentially lose you money. You can read more about this issue here.
It’s also worth noting, however, that the JLT study only looked at default funds. The difference in income achievable with a more specialised fund is potentially greater.
Because of the way pensions accumulate value over time, a few small actions taken now could make a huge difference to your final retirement pot.
When it comes to pensions, there is no such thing as a one-size fits all approach. It is very unlikely that a default fund will turn out to be better for you than one tailored to meet your needs, and this can make a significant difference to your income in retirement.
To make your workplace pension a better fit for you, talk to an independent financial adviser.
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