After choosing the fund, most people tend not to think much about their pension – other than how much they contribute each month – until the time comes to take a lump sum (or not) and purchase an annuity.
But in light of the economic turbulence of recent times, and the near-disappearance of final salary schemes, one would do well to pay attention to the markets and how pensions funds are affected. Your quality of life in retirement may depend on it.
The fortunes of pension funds have always been strongly correlated with the stock market – after all, a pension fund is really just a tax-efficient mutual with long-term goals – but with the demise of defined benefit schemes in favour of defined contribution, the connection has never been starker.
Most funds are a mix of stocks and bonds. Dependant on risk profiles, a common approach is to favour stocks to grow the fund before transitioning to the relative stability of bonds as you get closer to retirement. Therefore, how the stock market performs has a tremendous effect on the size of your fund by the time it comes to purchase an annuity.
A current 28 year old retiring at 70, saving £100 per month in a moderate-risk fund would be on track to have a retirement income of £17,600 per annum if the market performs well, but only £11,600 per annum if it performs poorly.
Even if you are lucky enough to be in a defined benefit scheme, the market can still affect your outcome – if the market takes a tumble the fund could end up with more liabilities than assets, meaning either it goes under, or you may not receive your full benefit. This is a real and looming threat, particularly for the public sector; but the private sector is far from immune.
Bonds and gilts
Bond market performance has wide reaching effects, from government policy to wider interest rates. They are of particular concern to those soon to retire.
Many pension funds engage in “lifestyling”, where the fund switches to bonds the closer you get to retirement, by default. The logic is sound – the nearer you get to drawing your pension, the more important it is that your income is fixed and you don’t risk your capital, even at the cost of lower yields.
But this balance between risk and yield could turn out to be unpalatably unfavourable depending on the state of the bond market. For example, the vast quantative easing programs the UK and US governments are currently engaged in have put bonds at a premium, effectively reducing the value of pension funds entering the “lifestyling” stage. You get less for your money.
Growing your fund
What this all means, is that rather than sticking money into a pension fund every month and forgetting about it, growing a fund that will provide the lifestyle you want in retirement may require some more active management.
For example, although most people are inclined towards low risk investments for their retirement, you may need the kind of growth that only comes with riskier securities, at least in the early stages of investment. This may require switching between different pension funds depending on both performance and what stage of life you’re at.
The key is to do as much as you can to reduce that risk. Ensure a diversified portfolio, spread investments between different countries – if the FTSE’s tumbling, that doesn’t mean the DOW is – and keep your eye on the long-term. When investing for 30 years or more, even the biggest crashes can become a relative blip.
The influence market performance has on the size of your pension fund – in a time when funds need to be bigger than ever to cover the cost of longer life – has contributed to the enormous popularity of SIPPs (Self-Invested Personal Pensions), where investors get direct control over where their money goes, while still retaining the tax-efficient wrapper of a pension fund.
The runway to retirement
It also pays to watch the markets when it comes to the ‘runway’ to retirement. Naturally, you will want to convert your assets into some sort of fixed-income, but timing can be crucial.
If you take your money out of stocks and in bonds at a time when stocks are high and bond yields are low, you could be doing yourself a disservice, significantly reducing your retirement income. It may be better to start your retirement by drawing down income from ongoing investments and waiting to switch to bonds and/or an annuity until conditions are more favourable.
But of course, drawing down carries far more risk – stocks can go down as well as up, and you may end up losing some or all of your capital at a time when you’ve stopped earning. The financial cost of mis-timing your switch to a fixed-income could be far outweighed by the peace of mind.
At a time when defined benefit schemes have all but disappeared, keeping an eye on markets is important to maximise your retirement income. But how much action you personally take should depend on your knowledge, inclination and propensity for risk.