The member of the scheme makes contributions which are placed in one or more professionally managed pension funds. These funds then invest in a range of stock and shares, bonds, cash, property and so on. Your contributions, and the returns they achieve, remain invested until you retire. At this point your pension pot is exchanged for regular income in retirement – your annuity.
Of course this approach varies a bit depending on the type of pension scheme and whether you receive employer contributions, but the general principle is the same.
Risk and reward
Different types of pension funds are designed to achieve different objectives. For example, funds will vary according to their level of risk, varying from low to medium and high. Generally, the potential returns are lower with low risk funds, with the converse generally the case for higher risk funds.
The performance of pension funds will depend on what is happening in the markets generally. A bad crash in the stock markets, as we saw in of October 2008, will affect the performance of the pension funds. Equally, the recent stock market rally in the final quarter of 2009 boosted the performance of the pension funds and negated the falls of the previous year.
Your attitude to risk will govern your choice of pension fund. Certainly, the nearer you are retirement the less time you will have to recover losses if the markets crash. As a consequence, you may want to start to play it safe and so change your fund to one with a reduced level of risk.
With-profits and unit linked
When you join a pension scheme you will need to decide which pension fund you want to use for your contributions. How your contributions are invested and the possible returns they may achieve will depend on the type of pension fund. In the UK there are generally two main types of managed pension funds – with-profits and unit linked.
A with-profits fund invests in a variety of equities and property as well as fixed interest and cash deposits. Each year the fund should pay a bonus, based on the performance of the fund and what the fund managers think is a reasonable amount given past and future expectation for investment condition. The idea is to smooth the peaks and troughs of the markets over several years. Generally with-profit funds are considered to carry a medium level of risk.
An advantage of a with-profit fund is that once the bonuses have been given they are guaranteed and cannot be taken away – even if the markets tumble. On retirement a final bonus may be awarded if the fund’s performance has been strong.
Unit linked funds on the other hand, fluctuate in line with the underlying investments and so are generally held to be riskier that with-profits. However over the longer term, the returns on unit linked funds may be better than with-profits. There are different types of unit linked pension funds, to cater to a variety of investment requirements. Common types of unit linked funds include managed funds (mix of equity, property and cash deposit investments), specialty funds (invest in one type of asset) and tracker funds (follow the performance of stock market index, such as FTSE 100).
Make the most of your pension
When it comes to investing your pension pot you will have a wide variety of choices. Be sure to consider your pension fund options carefully in line with your attitude to risk. Whether you go for a unit link fund or with-profits, monitor your funds performance to make sure it is really working for your retirement. Don’t be afraid to change funds if yours is underperforming, it is your future at stake.And make sure you get solid financial advice!