Best investment for your pension pot

Your pension is important, but do you know how it is invested or if your pension pot is looking healthy compared with the UK average? This article looks at these questions in detail and explores some of your options when you reach retirement. 

How are pensions invested? 

If you have a defined contribution pension scheme, so a scheme that is built up of yours and possibly your employer’s contributions, your pension is invested in a range of different funds.

A balanced portfolio for example, would consist of a range of equity funds (stocks & shares), bonds and cash funds. Selecting the best investment for your pension is important as it can make or break the quality of your lifestyle in your retirement years, so it’s vital you choose the right investments that suit your risk profile and situation.

There are many things you need to consider and here are just a few to think about when deciding where to invest your pension money.

Diversification is key

All investment portfolios should be diversified, and your pension pot is no different. This approach involves investing across many different funds and asset classes so that the overall risk is spread.

For example: 

If you placed £100,000 in Fund #1 and the fund went down 10% you would lose £10,000. However, if you were evenly invested in ten funds (Fund #1 to #10) with £10,000 each and Fund #1 reduced by 10% you would only lose £1,000.

There are thousands of different investment funds available in the UK. From investing in geographical & sector areas, to funds that are risk-adjusted to suit a particular risk profile, and lifestyle funds that alter their risk profile as you approach a target date.

No matter what, there is always going to be an aspect of risk in your pot.  Even holding cash has an element of risk as by purely holding cash, you risk the return not keeping pace with inflation, whereas an equity investment carries the risk of a reduction in capital.

Funds that invest in high-risk assets have the potential to produce higher investment returns over the longer term. But they may also lose value due to the volatility of the investment market.  

Active vs Passive - It' all jargon to me 

The funds within a pension can be managed differently. On an active basis, fund managers make all investment decisions with the aim of outperforming the market. They also manage downside risk.

A passive investment on the other hand will follow a relevant market index, such as the UK FTSE 100. In good years, passive funds will do very well, however if the markets fall, they will fall with the index, as there is no active management that can alter the investments in response to what’s happening in the markets. For this reason, passive funds are cheaper than the actively managed.

The best pensions are reviewed frequently. 

When investing in funds for your pension, remember to always review your portfolio regularly, particularly as you get closer to or start retirement. The future is uncertain, so it is important to make sure your investments continue to align with your goals and attitude to risk. As a minimum, reviewing each year to ensure you’re on track to meet your goals is sensible.

It is important to identify your risk profile before investing, speaking to an independent financial adviser can help with this.

What is the average pension pot in the UK?

According to the FCA, the average UK pension pot, after a lifetime of saving stands at just £61,987. Assuming you buy an annuity with this pot at a rate of 3.99%, you would only be receiving £2,473 per year.This is unlikely to be enough to live off, that is why it is advised to contribute as much to your pension as you can, from as early as possible.

"The average UK pension pot, after a lifetime of saving stands at just £61,987"

This does not include the new State Pension, which is currently £179.60 a week, therefore if you were in full receipt of the State Pension you would have an annual income of just over £9,338 a year. The State Pension cannot be accessed currently until you are 66. This will be rising to 67 between 2026 and 2028, therefore it is key to not rely on this if you intend to retire sooner.

According to the Pensions and Lifetime Savings Association, a modest annual income in retirement is £20,200 per year. It’s also important to note that people are living longer, which on paper is amazing, right? The problem that many in the UK could face though, is living longer than you’ve both anticipated and planned for.

To put this in perspective, a 65-year-old in England could expect to live on average to almost 84 if they are a man, while if they are a woman, they could expect, on average, to live to 86. So, those retiring need to make sure there is enough money to last.

At the Private Office (TPO) we create risk adjusted and objective-led portfolios to help you to get the retirement plan you want. The sustainability of your pension will be impacted by the amount of risk you take, the investment returns achieved, and how much will be withdrawn on a regular basis.

Controlling volatility and withdrawals from your pension pot in a falling market can be essential to ensure the long-term success of any retirement plan, especially when planning for when you begin to draw an income from your pension, known as the decumulation stage. Read our article ‘How to take an income from your investments without seriously damaging your wealth'.

What makes a comfortable retirement? 

The more you can put into your pension, the better chance you have of enjoying retirement. With pension freedoms, it is possible to start receiving your benefits and even retiring from the young age of 55 years old (rising to 57 from 2028).

No matter what, it is important not to have the attitude of too little too late - however it is never too late to start as every contribution made is boosted by tax relief, so even opening a pension a few years before your retirement has its benefits.

What is the best pension plan after retirement to suit your needs?

Now the fun part. You are about to retire; you have got years of relaxation (or adventure) ahead of you. So, what is the best pension plan to suit your needs? 

Let us explore some options: 

Firstly, you are entitled to receive 25% of your pension pot as a pension commencement lump sum (PCLS), which is a tax-free payment which most people can receive when they start accessing their pension benefits. It is normally 25% of the value of the pension benefits being accessed.

You do not have to take the whole 25% of your pot straight away. For example, say you have a pension pot of £400,000 and you want to access £100,000, £25,000 would be taken as a tax-free lump sum, whilst the remaining £75,000 is crystallised which means it can be taken as income as and when required and therefore will be taxed at your marginal rate.

The remaining £300,000 can remain untouched if that is your wish. The key benefit here is, that £300,000 that you haven’t crystallised can grow and the more it grows the more of it you can take tax free at a later stage. In addition, the funds that remain uncrystallised, remain outside your estate. This does not apply to funds that have already been crystallised  and withdrawn from the pension wrapper.

One thing to note is you can only take 25% of your pension tax-free if it falls under your remaining lifetime allowance, which for 2021/22 is £1,073,100 and is frozen at that figure until 2026. The remaining value will subject to income tax when withdrawn as income (as well as your excess benefits being subject to a lifetime allowance tax charge).

Now focusing on that remaining £75,000 in the example above, there are three options, either in stages or a combination of the following.  

1. Purchase an annuity.

This will provide you with a guaranteed income for life. The clear advantage is there is no risk of ever running out of money, and there is no investment risk.

However, an annuity is inflexible, you cannot change the amount of money you are getting per year (except if you have agreed at outset for it to rise by inflation for example), and annuity rates are currently very low. In addition, any “features” you elect for your annuity, such as indexation (increasing by inflation) or death benefits for your spouse or children will reduce the annual income that you can expect for the remainder of your life. It is also important to note these periodic payments are taxable.

 2. Place your pension funds in a drawdown plan. 

A pension drawdown plan is essentially an investment vehicle that allows you to flexibly access your money how and when you want it. Unlike an annuity, you could withdraw £1,000 one year and £10,000 the next.

You can also continue to invest your pension so it has a chance to grow, which depending on how long you live for, could be over 20 years.

Of course, however, there is added investment risk that may not suit some people. There is also the risk of spending too much too soon and being left without enough in the pot for the remaining years of your retirement. In addition, there is the reverse risk that you do not spend enough through fear of running out of money and have regrets in the future.

Just because you place some or all of your pension funds in drawdown, it does not mean you have to withdraw any of your pension straight away, it is entirely dependent on your situation. 

3. Take an Uncrystallised Funds Pension Lump Sum (UFPLS).

This involves taking some or all of your uncrystallised pension pot as a lump sum whereby you can withdraw a single or series of lump sums from your pension, of which 25% will be tax-free and the remainder taxable, without the need to move the funds into a drawdown plan first. 

Pensions also have favourable death benefits. If there is money left over, it can be passed on to whomever you have nominated, free of inheritance tax, as pensions do not usually form part of your estate. If you pass away before age 75 your nominated beneficiary receives the pension free of income tax. If the death is after age 75, it will be taxed at the beneficiary's rate of income tax when they withdraw any of the funds. 

This is a bit of a whistle-stop tour of the pension options available so if you would like to talk to us in a bit more detail about your retirement, please get in touch with a TPO adviser to arrange a free consultation today! 

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  1. The Daily Telegraph