A five-minute guide to pension funds

Staci West 02/10/2023 in Basics

What is a pension fund?

Imagine a pension fund as a special savings plan that’s designed to help you enjoy your retirement. It’s like a financial safety net you build over time. This fund can be made up of a mix of investments such as equities, bonds, cash, and property and – importantly – it is tax efficient.

You can receive money for your pension from three different sources. First, there’s the government, which provides a pension to everyone once they reach state pension age. Then, there are personal pensions you set up on your own. Lastly, most employers offer workplace pensions.

Depending on which type of pension you have, you might get to decide how your pension savings are invested. This way, you can make sure your pension investment plan fits your goals and lifestyle.

What do pension funds normally invest in?

Pension funds typically invest in a mix of assets such as equities, bonds, cash, and sometimes even property and infrastructure. These investments are chosen to help grow the money saved for retirement over the long term, with the goal of providing financial security during retirement years.

Do I need to make investment choices for my pension?

Whether or not you need to make active investment choices for your pension depends on the type of pension you have. In some cases, like defined benefit schemes, your employer or pension provider handles the investment decisions. However, if you have a defined contribution pension or a Self-Invested Personal Pension (SIPP), you may need to make active investment choices. It’s essential to understand your specific pension plan and consider seeking financial advice if you’re unsure about your role in managing your pension investments.

Different types of pension schemes

Workplace pensions come in two types: defined contribution scheme and defined benefit scheme. If you have a personal pension or SIPP, you’ll have more say in how your money is invested.

1. Defined Contribution Scheme

If you have a workplace pension with a defined contribution plan, your employer might offer you something called a “default investment fund.” This fund is designed for people who either don’t want to or aren’t comfortable making their own decisions about where to invest their pension savings.

Most workplace pensions will also give you the option to choose your own investment fund. However, this depends on the rules of your workplace pension plan. If you’re not sure which one is best for you, it’s a good idea to consider seeking financial advice to help you make the right decision. This way, you can pick the fund that suits your needs and plans the most.

2. Defined Benefit Scheme

If you’re part of a defined benefit scheme, your employer is the one responsible for handling all the investment decisions and taking on the associated risks to ensure you reach the pension amount that’s been promised to you.

3. Self-Invested Personal Pensions (SIPPs)

When you start your own pension, you’ll typically have to decide how to invest your money right from the beginning. Your pension provider will offer various investment options, but keep in mind that the available options can differ depending on your pension type and the provider you select.

If you opt for a SIPP, you’ll have more flexibility and control over your investments, with access to a wide range of assets. However, this option is most suitable for individuals who are comfortable making their own investment decisions.

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Can I choose where my pension savings are invested?

You can often choose where your pension investment fund is invested, depending on the type of pension you have. With many pension plans, such as defined contribution schemes or personal pensions, you typically have the option to select from a range of investment funds. This allows you to tailor your investments to align with your financial goals and risk tolerance.

Things to consider when choosing your pension investments

1. Long term outlook

Typically, you can’t access the money in your pension fund until you reach at least 55 years of age, and you may not need to until much later. Because of this long-term horizon, you can invest your pension money differently compared to short term savings that are used for day to day bills or your emergency fund.

It’s important to keep in mind that investments can fall as well as rise in value, but history has shown that, over time, values tend to increase, although it’s not guaranteed. If you have several years before you plan to start using your pension, there’s often enough time for your pension fund to recover from any short to medium-term fluctuations in the stock market.

2. Inflation

To ensure that the money in your pension pot grows over time and is worth more in the future than it is today, it must outpace inflation. If it doesn’t, the purchasing power of your money will diminish. Inflation is particularly critical to consider for pensions because they often span many years. Therefore, it’s important to explore investment options that aim to generate returns greater than the rate of inflation to preserve the value of your savings over time.

3. Risk

While it’s natural to want to protect your pension pot as you near retirement by avoiding any risky investments that can fluctuate in value, it’s important to consider that if you exclusively opt for lower-risk options like cash or bonds, you might not achieve your financial goals.

Historically, equities have shown better long-term performance compared to cash or bonds, although it’s crucial to remember that there are no guarantees, and past performance is not a guide to future returns. All investment funds are designed to grow over the medium to long term, but their risk level depends on the types of investments they hold. This risk profile essentially indicates whether the fund’s investments are low, medium, or high risk.

Funds that invest in higher-risk assets have the potential for greater returns over the long term, but they can also be more susceptible to market downturns and other factors, leading to potential losses. On the other hand, lower-risk funds tend to be less volatile but might generate lower returns over the long term. So, striking a balance that aligns with your own personal risk tolerance and financial objectives is important when choosing investments for your pension.

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4. Diversification

Diversification is crucial for your pension investments because it helps manage risk and potentially enhance returns over the long term. By spreading your investments across different asset classes, such as equities, bonds, and potentially other types of assets like infrastructure or commodities, you reduce the impact of poor performance in any one investment. This means that if one part of your portfolio experiences a downturn, other assets may perform better, helping to mitigate losses.

Diversification also aligns with the idea of not putting all your eggs in one basket. It helps you capture opportunities in various sectors or regions while lowering the overall risk of your pension portfolio. This balance between risk and return is essential to help your pension savings grow steadily and sustainably, increasing the likelihood of achieving your retirement goals.

5. Fees & Charges

All pension funds come with fees, and one common fee is the annual management charge. This charge is usually a percentage automatically deducted from your pension savings by your provider. These fees cover the costs of managing and investing your money. In many workplace pensions, these charges also handle administrative costs.

It’s essential to carefully review and compare all charges when evaluating different pension providers. Remember that regardless of how well your investments perform, you’ll have to pay these charges over time and these fees can significantly impact the final amount you receive.

Remember, higher charges may be justified if a skilled fund manager has the potential to achieve better results. However, it’s crucial to note that past performance is not a reliable indicator of future performance, so always remember to do your research.

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Should I invest more into my pension?

Deciding whether to invest more in your pension depends on your individual financial circumstances, goals, and retirement plans. While investing more in your pension can enhance your retirement prospects, it’s important to evaluate your circumstances and objectives carefully. Here are some factors to consider: retirement goals, current financial situation, employer contributions and tax advantages.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.