Pension auto-enrolment was launched in 2012 and has been a huge success.
It stipulates that all employees who meet certain requirements (re: age and earnings) must be enrolled into a workplace pension scheme, along with some minimum level of pension contributions for both the employer and employee.
This has vastly increased the amount that people are saving towards retirement.
However, one area where there is still work to be done is in the underlying investments within those pensions.
One size doesn’t fit all
According to a previous article in Investor’s Chronicle, “about nine in ten people who are enrolled in a DC [defined contribution] workplace pension scheme keep their investments in the default strategy designed by the pension provider.”
Furthermore, most pension schemes operate so-called ‘lifestyling’ strategies whereby the underlying investments are gradually and automatically ‘de-risked’ as you approach a pre-determined retirement age, which you may well have specified many years ago when you started the job.
As the article states “pension default funds… are designed to make do for most people rather than be the best option for you.”
Performance risk
Default investment strategies vary from pension scheme to pension scheme, but are normally along the lines of the following:
- In the pre-retirement phase (say at least 5 years before the specified retirement age), the portfolio will typically consist of 60-80% global equities, 20-30% bonds, and 0-10% ‘alternatives’ (commodities, property, etc.),
- As you move closer to retirement age, the equity allocation is reduced in favour of cash and bonds, according to the aforementioned lifestyling strategy. The idea here is that as you draw closer to retirement, your ability to withstand short-term market volatility reduces.
This will be suitable in some cases, but certainly not all.
One potential risk, and something we frequently observe, is that younger people are investing too defensively and that could be a major drag on long-term returns.
Worked example
Consider the following example:
- Desmond is 22 years-old and has recently finished university. He has joined a law firm in London as a trainee, with a starting salary of £45k a year.
- As part of this, he’s enrolled on the company pension scheme – he contributes 5% of his salary each year and his company pays 8%.
- This is invested in the default investment strategy, a portfolio that has a 60% allocation to global equities, and 40% to bonds (a classic 60/40 mix).
- I assume his earnings rise 5% a year and that he stays at the same company for his whole career, before retiring at age 60. And for simplicity, I assume no lifestyling.
- In terms of potential investment returns, I use the Vanguard LifeStrategy ‘LS’ series as a proxy – one of the most widely used multi-asset funds in the market.
- The Vanguard LS 60% Equity fund (implies a 60% allocation to equities, 40% to bonds, in line with Desmond’s default strategy) has returned an average 6.6% pa over the last ten years. If we were to extrapolate this and combine it with Desmond’s contributions and earnings growth, this would imply a pension value of approx. £1.29m by age 60, or c. £420k in today’s price terms (i.e. adjusting for inflation at an assumed 2.5%).
The question here is whether a 60/40 portfolio is appropriate for Desmond?
He has a very long investment timeframe – he cannot access his pension until Minimum Pension Age, likely 58-60 in his case, and has excellent earnings potential.
These factors would imply a high ability to withstand any near-term market volatility in pursuit of superior long-term returns.
- Say he were to invest in an 80/20 portfolio (i.e. 80% equities, 20% bonds) instead…
- Again, using the Vanguard LifeStrategy fund range as a proxy, the 80% equity version has returned an average of 8.4% pa over the last ten years.
- That would imply a pension pot worth £1.90m by Desmond’s intended retirement age, or £617k in today’s price terms, some 47% higher than the default.
- Using a simple 4% safe withdrawal rule (proxy for a sustainable income), this translates to additional spending tolerance of around £7.9k a year.
- What about 100% equities, which one could make a reasonable case for given Desmond’s earnings and timeframe?
- The Vanguard LS 100% Equity fund has returned an average 10.3% over the past ten years, which translates to a pension worth £2.9m at Desmond’s intended retirement age, or £947k in today’s money (125% higher than the default and implying additional spending tolerance of around £21k a year vs the original).
Here’s a very simple chart showing the difference in final pension values based on the three return scenarios above:
Disclaimer: These figures above are for illustrative purposes only and do not reflect actual investment returns, which can fluctuate and are not guaranteed. A pension is a long-term investment and funds are not normally accessible until 55 (rising to 57 from April 2028). When investing via a pension, your capital is at risk. The fund value may fluctuate and can go down which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
Whilst the above examples are somewhat extreme, the huge differences in final pension values highlight the dangers of inertia – leaving funds in default investment strategies which may be too defensive for your own needs.
Conclusion
We would encourage you to check any workplace pensions and ensure you’re taking the ‘right’ amount of risk, which should be a balancing act between your willingness and ability to withstand market volatility.
Too much investment literature focuses on investment risk in terms of the volatility of returns, but this is merely part of the ‘investment journey’. In contrast, little is said about the risk of being invested too defensively and the impact on wealth creation and future spending tolerance. This can be substantial where the effect is compounded over a very long timeframe.
Disclaimer: Workplace Pensions are regulated by The Pensions Regulator.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
