Know what your pension is invested in – or risk losing it all

The recent stock market crash in China – which knocked billions off the value of pension funds across the world – showed just how important it is to know exactly what your pension is invested in. Had you a pension that was heavily invested in Chinese shares, much of your life savings would have been wiped out by that crash.

Thankfully, most Irish people hold pensions that are not too heavily exposed to Chinese shares. However, many had poured their life savings into the shares of Irish banks before this country’s banking crisis hit in 2008. Those life savings were virtually wiped out overnight when the banks collapsed and their share prices plummeted.

So understand exactly what your pension is invested in – and what your chances are of losing it should things take a turn for the worse.

Many of us with private pensions have defined contribution schemes, where the value of your pension depends on how much you and your employer (if it chooses to do so) pays into the pension scheme over your working life and how well that money was invested.

The other type of pension is a defined benefit scheme, which traditionally ‘guarantees’ to pay a percentage of your salary when you retire. However, many defined benefit schemes have run into financial difficulties in recent years, with some paying only a fraction (if any) of the pension they had originally promised. This is why there has been a growing shift towards defined contribution schemes of late.

With defined contribution pensions, you could still get a fraction of the pension you expect when you retire – if your money has not been invested wisely.

How do I invest my pension wisely?

When you first start saving into a defined contribution scheme, you must decide on the investment funds that your pension will be invested in. Bear a number of things in mind before choosing these funds – how much time you have to save and invest for retirement, how much risk you are confortable with, and how much money you will need when you retire.

Understand the risks that you take on when you invest in a particular fund and be sure that the amount of risk you’re carrying is suitable for someone of your age. Generally, the longer you have until retirement, the more risk you can take. However, should you only have a few years to go until retirement, you can’t afford to have your money tied up in risky funds as you have very little time to make up for any losses should those investment funds perform poorly shortly before you retire.

What’s my choice of pension funds?

The funds you can invest in through your pension range from ones with a very low risk (such as cash funds), to ones with a high risk (such as equity funds and property funds) to very high risk funds (such as geared funds). In the middle are balanced funds.

Cash funds, which are similar to deposit accounts, typically don’t go up or down in value. However, as the return is low and inflation eats into the value of cash funds over time, they are only suitable if you are close to retirement.

Balanced funds are typically managed funds, where your investment fund is run on your behalf by an insurance or investment company. They’re described as medium-risk funds because although the value of the funds rise and fall over time, the investment returns are expected to be smoother than equity funds. Balanced funds are usually suitable for those who are not close to retirement.

Equity funds are made up of shares in companies traded on stock markets. The value of these funds goes up and down over time – and sometimes the swings can be very dramatic. Equity funds are usually suitable for those who have a long time to go until retirement. Good equity funds have historically offered better returns than other types of investments – and they usually beat inflation.

Property funds, which typically invest in commercial property and may invest in Real Estate Investment Trusts (REITs), are also risky and so usually suited to long-term investors.

With geared funds, a certain amount of money in the fund is borrowed in a bid to boost investment returns. However, these funds can be incredibly risky and should only be considered by long-term investors – if at all.

Why does my age matter when investing my money?

Most people split their pensions savings across a number of funds so that they’re getting exposure to different investments and various levels of risk rather than pouring all of their money into a risky – or low-risk – fund.

Your age should have a big bearing on how you split your pension savings.

A 30-year-old should consider investing most – if not all – of his pension savings in a high-risk equity fund, said Vincent Digby, managing director of financial advisers Impartial.

“Equities over the long term have produced superior returns,” said Mr Digby. “As you are making regular contributions to your pension, you will continue to buy units at cheaper prices if the market falls in value. Don’t worry if the market falls – it’s the time you are in the market that works in your favour, so start saving for your pension early and don’t worry about short-term market movements.”

Zurich Life’s International Equity Fund and Five Star Five Europe Fund are two funds tipped by Mr Digby for a 30-year-old who is just starting his pension. Smaller company funds (which typically invest in companies at an early stage of their growth), such as those offered by Zurich Life and Standard Life, are also recommended by Mr Digby.

A 60-year-old who is about five years away from retirement, however, should be reducing the amount of risk that his pension savings are exposed to – particularly if planning to buy an annuity (a product bought from an insurance company at retirement which pays you a set income for the rest of your life).

“If you are 60 years old, you should be moving 20pc of your pension savings a year into cash funds over the next five years,” said Mr Digby. “You should also make sure the rest of your savings [that is, those that have not been moved into cash funds] aren’t in something too high-risk.”

You may be considering putting your money into an Approved Retirement Fund (ARF – a personal retirement fund where you can keep your money invested after retirement) when you retire, rather than buying an annuity. “In such a case, your approach [to the investments your pension savings are in] should be entirely different as you are going to be continuing to carry investment risk after you retire,” said Mr Digby. “A 60-year-old should look at the potential worst-case scenarios for the level of risk they are currently running. If the potential drops are too scary, look at gradually de-risking until you are comfortable with the maximum potential downside. The key here is to avoid running too much risk, getting beaten up in a bear market and bailing out at the wrong time – and missing the subsequent recovery.”

You can change the funds that your pension savings are put into over your working life – and indeed, you should regularly review your choice of funds and check how well those funds are performing.

Most pension providers offer ‘lifestyle’ pension schemes, where the bulk of your pension pot is moved from the traditionally more volatile equities into investments that are expected to be more stable the closer you get to retirement. However, lifestyle pensions don’t always deliver the best returns – and they may be unsuitable if you’re not planning to buy an annuity when you retire.

How should I invest my defined benefit pension?

You don’t have much, if any, say on how your pension is invested if you have a defined benefit scheme, as it is the trustees, in conjuction with the scheme’s investment manager, who decide how the money is invested. That doesn’t mean you should sit idle, however.

Poor investment could be one of the reasons a defined benefit scheme is running out of money. You’ll only get fraction of the pension you were expecting at retirement if there’s a black hole in such as scheme – if you get any pension at all. You should therefore check how well or poorly funded your defined benefit scheme is.

If you’re concerned that it could run out of money, make alternative arrangements so you won’t be completely reliant on that scheme should it run into trouble. You could, for example, make contributions to a separate Additional Voluntary Contribution (AVC – a type of pension top-up) scheme. You could also consider transferring the pension you have built up in your defined benefit pension to a defined contribution scheme – but be sure you don’t take much of a financial hit should you do so.

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