Don't let your pension crash just before you retire

by Ed Bowsher on 14 April 2011  |  2 comments
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New research shows that those closest to retirement are most in danger of losing substantial pension income.

I’ve said several times on lovemoney.com that I believe that investing in shares is the best way to build long-term wealth for your retirement. However, there are risks and those risks are greatest when you’re approaching retirement.

Let’s imagine you’re 40 and you’ve got £50,000 invested in stocks and shares. The stock market crashes and the value of your investments tumbles to £30,000. You’ll probably be pretty fed up when this happens but there’s no need to panic. That’s because history shows that stock markets nearly always recover from crashes eventually. If you’re only 40 when a crash happens, you can wait 25 years for share prices to pick up again, and you can still retire with a decent sum of money.

But if a crash happens when you’re 64, and you’re fully invested in the stock market, you could be in trouble. The value of your investments could tumble just before you retire.

Look what happened in the financial crisis. The value of the UK’s FTSE 100 index almost halved in value over an 18 month period. So if you were fully invested in shares and chose to retire in March 2009 – when share prices were at their lowest – you’d have been much poorer than if you had chosen to retire two years earlier.

Of course, it’s one thing to have a small portfolio of shares that gives you some extra wealth in addition to your pension. But those of us with defined contribution pensions could see the value of our actual pension fall dramatically in the event of a financial crash.

In fact, Annuity Direct, an annuity provider, calculates there is a 1 in 20 chance of you losing over 22% of your pension if your pension pot is invested solely in shares during the year before your retirement.

Reduce your risk

The normal way to stop this happening is to gradually move your money out of the stock market in the years leading up to your retirement. Cash and bonds are lower risk than shares, so if you move money to cash and bonds, you’ll be less likely to see a dramatic fall in the value of your pension.

Managing that switch away from the stock market can take time and skill which is probably why many people don’t do it, they just ‘set and forget’ their portfolio.

One solution to this problem is 'target date' funds. Here's how they work:

Let’s say that you’re planning to retire in 2025. You could buy a 'UK Shares 2025’ fund. The fund would be managed on the basis that all of its investors are due to retire in 2025 and the fund will be wound up at that date. So the fund manager gradually sells shares and buys bonds during the run-up to 2025. As a result, no investor in the fund should be subjected to any undue risk. If you’re younger and plan to retire in 2040, you could invest in a 2040 fund, the same for 2045.....

Target date funds are widely used in the US but not in the UK. However, that looks set to change as the Government’s new pension scheme, NEST, will offer target date funds. I suspect they will be a popular option.

That said, I don’t think target date funds are the perfect solution for everyone. The problem is that some people only start saving for their retirement at a relatively late stage in their life. If you start saving for a pension at 45, and then start switching out of the stock market aged 50, you’re not going to get much benefit from the long-term wealth-building properties of stocks and shares.

So you may need to stay 100% invested in stock and shares until you’re much closer to 65. That’s a risky move but the extra risk is the price you pay for starting your pension at a relatively late stage in your life.

More:  A better way to  build a pension