A better way to build a pension

by Ed Bowsher on 09 November 2010  |  3 comments
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A better way to build your pension pot may be coming to the UK.

This post is all about defined contribution pensions. If you’re lucky enough to have a final salary pension, you probably don’t need to read this. Go away and have some fun!

Many of us, however, are going to have to rely on defined contribution pensions in our sunset years. We need to build a pension pot that is large enough to give us a decent retirement income.

Building that pot can be tough. You want your pot to grow as fast as possible, so putting your money in stocks and shares looks attractive at first glance.

On the other hand, half of your pension savings could go up in smoke in a stock market crash - a pretty scary thought! What’s more, some of us have little control over how our pot is invested which can make the whole process even scarier.

In the UK, the traditional way to reduce the fear has been ‘lifestyling.’ The idea is that as you get older, your pension pot is gradually moved out of shares and into lower risk assets such as bonds and cash. There are two reasons for this approach:

Reason one

If you’re young, a stock market crash isn’t a disaster. In the past, if you held onto your shares for 20 years or more, you’ll have nearly always come out fine. So if you’re 35 and your pension pot is hit by a crash, it will almost certainly have recovered by the time you reach 60 or 65. In fact, you’ll have probably done better staying in shares rather than switching to cash or bonds.

However, shares don’t always come out best over shorter time periods such as five or ten years. So if you’re ten years away from retirement, it makes sense to move some of your pot away from shares.

Reason two

If things go dramatically wrong when you’re young, you have more time to recover from the disaster. You can work harder, spend less or do whatever is necessary. That’s much easier to do when you’re 30 than when you’re 50. So when you’re 50, it makes sense to reduce the risk by gradually moving out of shares.

Drawbacks

Lifestyling is an attractive option in many ways but it has drawbacks. Firstly, many people don’t start saving for a pension until they’re in their 40s. That’s far from ideal; you’ll do much better if you start saving at a younger age.

But we have to accept reality. Lots of people start in their 40s and many won’t have had time to build a large pot by the time they’re 50. So it may be worth staying 100% invested in the stock market for some years beyond 50 – yes, the risk is higher, but taking that risk may be the only realistic way to build a pot that is large enough.

The second drawback to lifestyling is that it can be fiddly and costly. The Americans have a solution though. It’s called a target date retirement fund.

Let’s say you’re 30 at the moment. You may be hoping to retire when you’re 65 which will be in 2045. In the US, you could go and buy a retirement fund with a target date of 2045. That fund will probably be fully invested in equities at the moment but as we get closer to 2045, the fund manager will gradually switch into other assets. If you’re 40, you could invest in a 2035 fund. If you’re 50, a 2025 fund and so on.....

Because you’re not switching between funds, the risk management process is cheap, simple and hassle-free.

Sadly, there are no target date funds available in the UK market. But that may change. A US fund manager, Vanguard, is considering launching a range of target date funds in the UK. Vanguard is famous for offering low cost tracker funds in both the UK and US, so this is really great news.

The easy option

And target date funds don’t just offer an alternative to ‘lifestyling.’ They may also become the standard for default funds. Many people with defined contribution pensions are given a restricted choice of funds in which they can invest – assuming they have any choice at all. When given this choice, many folk pick the default fund. It looks like the easy option.

Default funds try to offer an ‘all things to all men’ approach which comprises a mix of shares and bonds. That sounds reasonable, but as we’ve already seen, different combinations of shares and bonds are appropriate for different ages. The default fund may be too risky for older savers but not risky enough for their younger colleagues.  Allowing savers to pick an appropriate target date fund would make much more sense.

As I have a SIPP, I have full investment control over my pension pot. If Vanguard does launch some target date funds here, I’ll seriously consider putting a big chunk of my SIPP in an appropriate fund for my age.