Invest Wisely: Strategies From Pension Funds For Long-Term Growth

Pension funds are a long-term, tax-efficient savings plan that you can access in later life when you want to work less or retire. They are made up of a portfolio of assets, including stocks and shares, bonds, cash and commercial property.

Pension fund assets must be prudently managed to ensure that retirees receive their promised benefits. Historically, pension funds have primarily invested in stocks and bonds, but in the 2020s, they are increasingly investing in a variety of asset classes, including private equity, real estate, infrastructure, and securities like gold.

When deciding how to invest your pension fund, it is important to consider your attitude to risk, where your pension funds are currently invested, how you plan to take your benefits, and when you plan to access your pension savings.

If you are a cautious investor, you may prefer lower-risk funds such as cash, deposits, fixed interest, or bond funds, which aim to deliver security rather than growth. On the other hand, if you are an adventurous investor, you may be comfortable with higher-risk funds that invest heavily in equities.

It is also worth reviewing your investment choices regularly, especially as you approach retirement, to ensure they still align with your goals and risk tolerance.

Understand the different types of pension schemes

Pension schemes are a type of savings plan that helps you save for later in life. They are one of the best ways to grow your money steadily over time. There are three main types of pension schemes in the UK: defined contribution pensions, defined benefit pensions, and state pensions.

Defined Contribution Pensions

Defined contribution pensions are sometimes called 'money purchase' pensions or pension pots. These schemes are very common today and can be set up personally or as a workplace pension. Money is paid in by you or your employer over time and is invested by the pension provider. The size of your pension pot at retirement depends on how much was paid in and how well your investments have done. You can usually take up to 25% of the amount built up in any pension as a tax-free lump sum. With a defined contribution pension, it's up to you how you take your money out. You should get to know all your options before deciding what works best for you.

Defined Benefit Pensions

This type of pension scheme has declined in popularity and is nearly always arranged by your employer. It is sometimes referred to as a 'final salary' or 'career average' pension. Defined benefit schemes give you a guaranteed annual pension worth a certain amount at retirement. The value of your pension depends on your earnings, how long you've worked for your employer, and the terms of the individual pension scheme.

State Pension

This is the pension that you need to claim from the government when you reach state pension age. The maximum you can currently get from the state pension is £221.20 per week, which works out to £11,502.00 per year. The maximum you can get is dependent on your individual working history and how much NI (National Insurance) contributions you've made in your working life.

Know how to choose the right pension fund

Choosing the right pension fund is a complex decision that requires an understanding of your financial goals, risk tolerance, and investment options. Here are some key considerations to help you make the right choice:

• Understand your risk tolerance: Before choosing a pension fund, assess your comfort level with risk. Are you cautious, aggressive, or balanced in your investment approach? Cautious investors typically prefer lower-risk funds such as cash, deposits, fixed interest, or bonds. Aggressive investors are comfortable with higher-risk investments like equities and aim for higher returns. Balanced investors seek a mix of higher and lower-risk assets.
• Diversify your investments: Diversification is a crucial strategy to manage risk. Consider spreading your investments across different asset classes, sectors, and geographic regions. This helps protect your portfolio from the potential decline of a single investment type and takes advantage of opportunities across the market.
• Consider your time horizon: Your investment horizon, or how long you plan to invest for, is an important factor. Generally, younger investors can tolerate more risk as they have a longer time to recover from market downturns. As you approach retirement, shifting towards more stable assets like bonds and cash can help minimise the impact of market volatility on your portfolio.
• Review fund options: Familiarise yourself with the fund options available through your workplace pension or personal pension plan. Workplace pensions may offer a default investment fund, which is designed to reduce risk as you get closer to retirement. Personal pension plans often provide a broader range of investment funds to choose from, allowing you to tailor your investments to your specific goals.
• Seek professional advice: Choosing a pension fund can be complex, and it's important to make informed decisions. Consider seeking advice from an independent financial adviser (IFA) who can guide you based on your circumstances and goals. They can help you navigate the thousands of investment funds available and explain the intricacies of each option.
• Monitor and review your investments: Remember to regularly review your investment choices to ensure they remain aligned with your risk tolerance and financial goals. As your life circumstances change, you may need to adjust your investment strategy accordingly.

Learn about asset allocation

Pension fund asset allocation is a complex topic, and it's always recommended that you seek independent financial advice before making any investment decisions. That being said, here is some general information about asset allocation when investing like a pension fund.

Pension funds have traditionally been limited to investing in government securities, investment-grade bonds, and blue-chip stocks. However, changing market conditions and the need to maintain high returns has led to a shift in investment strategies. Pension funds now invest in a wider variety of asset classes, including private equity, real estate, infrastructure, and inflation-hedging securities like gold.

When investing like a pension fund, it's important to consider the level of risk you are comfortable with. Pension funds tend to be relatively conservative in their investment strategies to ensure they can meet their payout obligations. As such, fixed-income securities and blue-chip stocks still make up a large portion of pension fund portfolios.

However, pension funds also seek higher returns to cover their guaranteed payouts. This has led to an increase in investments in high-yield bonds, commercial real estate loans, and riskier stocks. Additionally, pension funds are investing in asset-backed securities like student loans and credit card debt, which carry a higher risk but offer the potential for higher returns.

Another important consideration when allocating assets is the time horizon of the investment. Pension funds are long-term investments, and this allows them to invest in riskier assets that may fluctuate in the short term but have the potential for higher returns over the long term. As such, company shares are a common investment choice for pension funds, as they have historically performed better than cash or bonds over the long term.

Diversification is also key to pension fund asset allocation. By spreading their investments across a range of asset classes and investment types, pension funds can protect themselves against losses if a particular investment falls in value. Diversification also helps to minimise the impact of market volatility and take advantage of opportunities across different markets.

Finally, when allocating assets, pension funds need to consider the charges associated with different investment funds. Annual management charges can vary significantly between funds, and these charges can make a big difference to the overall returns of an investment.

Explore tax-advantaged accounts

Tax-advantaged accounts are a great way to invest for retirement. These accounts, such as 401(k)s and individual retirement accounts (IRAs), provide tax-deferred or tax-free growth, making them ideal tools for retirement investing.

IRAs and 401(k)s are available in "traditional" and "Roth" options. Traditional accounts may let you deduct your contributions from your taxes now, and you pay income taxes when you make withdrawals in retirement. With Roth accounts, you invest with money you've already paid taxes on, and withdrawals in retirement are tax-free. There are additional rules to be aware of with Roth accounts.

Both 401(k)s and IRAs have annual contribution limits, but they can help you save hundreds of thousands of tax-advantaged dollars over your working life.

If you're in the UK, you can take the whole of your pension savings in one go. A quarter of your pension savings can usually be taken tax-free; the rest will be taxed as income. You will need to plan how you will provide an income for the rest of your retirement.

You can also leave your pension savings invested and take one-off lump sums or a regular income. Again, a quarter of that amount can usually be taken tax-free, with any regular income being taxable. The amount left in your pension savings remains invested, giving it a chance to grow, although it could also decrease in value.

If you want a lifelong, regular income, you can get a guaranteed income for life, also known as an annuity. A quarter of your pension savings can usually be taken tax-free, and any other payments will be taxed as income.

You can also leave your pension savings invested and take lump sums as and when you need them. A quarter of each lump sum taken is usually tax-free; the rest will be taxed as income. You decide when and how much to take out.

Consider investing in dividend-paying stocks

Pension funds have historically invested in stocks and bonds, but changing market conditions have led to a shift towards a more diverse range of asset classes. One such asset class is dividend-paying stocks, which can be a key element of a portfolio.

Dividend-paying stocks can provide a steady and dependable income stream, with dividends typically being paid quarterly. This income can help meet liquidity needs and provide a partial return on investment, even if the stock price does not increase. Dividend-paying companies tend to be larger, more mature, and stable businesses that consistently increase their dividend payouts over time, making them less vulnerable to market downturns.

Dividend-focused investing has been shown to lower volatility and buffer losses during market downturns. Dividend-paying stocks tend to be less volatile than non-dividend-paying stocks and can provide a hedge against inflation, especially when dividends grow over time. Additionally, dividends offer tax advantages, with qualified dividends being taxed at lower rates than ordinary income.

When considering investing in dividend-paying stocks, it is important to look beyond just the dividend yield. It is crucial to evaluate the company's financial health, growth prospects, and how the investment aligns with your goals and risk tolerance. Dividend-paying stocks can be a valuable component of a pension fund's portfolio, providing income, reducing risk, and potentially generating long-term returns.

Frequently asked questions