Over the last few years many of us have seen our pension funds make a loss or, at best, break even. The search for a decent return has led many investors to turn to higher-risk investments, but is this a good idea when you are risking the money you need for your retirement?
It is always a good idea to start investing for your retirement as early as you can afford to. By the time many of us in the UK come to retire, a state pension will not provide a comfortable retirement. If you want to match the salary of a backbench MP (currently £63,738) then you would need a pension pot of £1.84m. To retire at 65 with an income the same as the national average wage (£25,500) you would need a pension pot of £550,000 (figures provided by AJ Bell).
So how can you make the most of your retirement assets?
UK pension schemes
There are numerous different types of pension scheme available. You should make the most of any employer contributions and tax advantages. The type of pension you select will determine when and how you can claim your pension and also how it is taxed. The main types of pension available in the U.K. are:
- Occupational pensions (or company pensions). From October 2012 onwards, employers are legally required to enrol their employees into a pension scheme and make contributions for them.
- Personal pensions. You can choose to join a personal pension scheme whatever your working circumstances are. These schemes are set up and run by financial institutions and you can choose to have a personal pension in addition to any occupational pension you may have in place.
- Stakeholder pensions. These are a type of personal pension which have to meet certain standards including a 1.5 per cent cap on annual management charges. Contributions to this type of fund are flexible so you can stop and start payments and change the amount of your pension investments.
So how should I allocate my retirement assets?
The old rule of thumb is that you should subtract your age from 100 and this is the percentage of your investment capital that should be used for stock investments. The remainder should be invested in lower risk assets.
However, some commentators are suggesting that you should subtract your age from 110 or even 120. This is due to the fact that life expectancies have increased and your pension fund needs to last for a longer time than in the past. Also the U.K. pension age is being increased so, if you would like to retire before you are 70, you will need to ensure you have adequate pensions and savings to live on. We will use 110 for our calculations to account for the above changes.
In the early stages of your working life, you can afford to take on more risk and select a greater proportion of high risk assets to make up your investment portfolio. Even if some of your high risk investments do not perform as well as hoped, you have many years to recoup any losses and turn a profit.
So, if you are aged 20-30 then you should invest aggressively, with 80-90 per cent of your capital invested in stocks. The remainder should be used to buy lower risk assets. The hope is that your higher risk stock investments will earn you a greater return than lower risk assets and help you to increase your pension pot at an early stage.
As you move into your 30s, your investments should be more moderate, with 70-80 per cent of your capital in stocks. The remainder should be invested in lower-risk investments such as mutual funds and bonds.
To aim for a higher return on your bond investments you could invest in corporate bonds, which pay out more than government bonds and are higher-risk. A mutual fund pools your money with that of other investors and invests it in a mix of stocks, bonds and cash. Professional asset managers use sophisticated software such as that provided by Sungard.com/APT/ to manage their funds. There are numerous mutual funds to choose from and you can afford to select higher risk funds at this stage.
Pension fund risk should be reduced as you approach retirement and your investments should be increasingly conservative as you move through your 40s. You should reduce your investment in stocks to a maximum of 60-70 per cent of your capital. You could also select stocks in well-established companies to further reduce the risk.
The rest of your capital should be invested in lower-risk investments. You should consider choosing government bonds instead of corporate bonds – these offer less risk and correspondingly lower payouts. You should also look to invest in lower-risk mutual funds.
Age 50 – 60+
From the age of 50 until retirement, your priority should be maintaining your pension pot and avoiding any losses. It is important to remember that there is no such thing as a risk-free investment, but you can take a number of steps to mitigate the risk.
You should invest conservatively, with a maximum of 50-60 per cent of your capital remaining in stocks. To reduce the risk as much as possible, these stocks should be in reliable companies with a proven track record.
Your remaining 50-60 per cent should be invested in low risk assets. Government bonds are considered very low risk because they provide fixed interest payments and return of the capital sum invested on a specific date. If you are buying government bonds then you should ensure you are investing in a politically stable country and also be aware of fluctuations in the exchange rate which will affect any profits if you invest abroad.
Whatever your age, it is important to regularly review your investments to ensure that they still meet your needs.