Auto-enrolment means many more workers are now paying into a pension – but the default funds are often a poor choice. Take the time to pick your own, says Cris Sholto Heaton.
The introduction of auto-enrolment for workplace pensions over the last few years means that most people in the UK will now be paying into a company pension. And while minimum contributions to a workplace pension are still too low to fund a decent retirement alone, they will rise to a combined employer and employee contribution of 8% in April 2019 – large enough that you can’t ignore them altogether. So anybody who hasn’t checked how their contributions are invested and whether the default choices are appropriate for them needs to spend at least a little bit of time thinking about their options.
The problem is that many workplace pensions don’t offer the best investment choices. Obviously, you won’t have the same flexibility for choosing your investments as you’d get with a self-invested personal pension (Sipp) – that goes without saying. And to be fair the choices seem to have got better over time – I see fewer workplace pensions these days (especially the new low-cost auto-enrolment ones) that simply ask you what level of risk you can tolerate and then stuff you into a poorly constructed basket of fashionable and expensive funds. But in many cases, the automatic option is still some kind of deeply uninspiring multi-asset fund (one that holds a mix of different asset classes) that aims to be an acceptable choice for anybody and ends up being a good one for almost nobody. While the best choice depends both on your own circumstances and the funds available in your workplace pension, there are a few principles you can use to pick something that might perform better.
Three principles for better investing
First, get the right asset allocation. This refers to the split between different assets such as stocks and bonds in your portfolio. The default fund in most workplace pensions will usually be either a traditional multi-asset fund or a lifestyle fund (which is essentially a multi-asset fund that increases the proportion of bonds and decreases the proportion of stocks as you get older). The logic behind this is that shares have higher potential returns but also have a higher risk of losses, especially over short time periods. As you get closer to retirement, your ability to take big losses decreases (because there’s less time for your portfolio to recover before you need the money) and so older investors should have more in bonds to reduce these risks.
The idea behind this is sensible, but the reality is that many multi-asset funds hold too much in bonds. While not many assets are cheap today, bonds look even worse long-term value than equities, so it is hard to justify keeping much of your portfolio in them if your aim is long-term growth. It’s true that there is a high risk that shares suffer big short-term losses in the next decade – perhaps even a 50% fall from peak to trough. That’s a worrying prospect for new investors, so you can see why pension schemes think it’s safer to put everybody in a multi-asset fund that has, say, 50% of its assets in bonds. But doing this almost guarantees they will have much worse long-term returns. People who are many years away from retirement are better off investing in shares and learning to live with the extra volatility.
Second, battle against home bias. Many investors keep most of their money in domestic assets because they know their local market best – for example, a British investor keeps most of their money in UK shares. For most people, this makes no sense. Risks such as your job security and the value of your house typically depend very heavily on the economic performance of the country you live in – so it increases your financial risks if you have most of your investments in that country’s stockmarket as well. The UK accounts for about 5% of global stockmarket capitalisation, so you might rationally have about 5%-10% of your money there. Yet I see international stock funds for workplace pensions that have 50% of their assets in local shares and 50% overseas. These make no sense – investors reduce their risks by being as international as possible, not by clinging to the UK.
Third, opt for index funds (also known as passive funds or tracker funds) rather than active funds (also known as managed funds). Index funds try to match the performance of the overall market. Active funds try to beat it – and the vast majority fail. This is true in bear markets as well as bull markets (active managers like to claim that they can help shield you from losses at turbulent times – but most don’t succeed). And it’s true in emerging markets as well as developed markets (even though most emerging market indices are constructed worse than developed-market ones and should be easier to beat). On average, cheap index funds will give you better results than expensive active funds.
Yes, some managers may have the ability to beat the market over time. But identifying them is not easy – it requires expertise of your own. And the reality is that skilled managers aren’t working for the insurance firms who run most workplace pensions – they prefer somewhere a little less bureaucratic. Many pension schemes include access to a small number of external funds – but these usually have higher fees and don’t normally include the best active funds, which tend to be small funds from specialist managers. So in most cases, it’s best to stick to index funds.
Aim for a cheap global portfolio
Put this all together and the best choice is typically a low-cost index fund invested in global shares. If you’re close to retirement, you might want to add some bonds to that mix as well, but younger investors will almost always be better off with 100% equities.
Many workplace pensions now offer a few low-cost index funds. Hopefully one will be a cheap, simple, well-balanced global stock fund – in which case that’s all you need. If not, you may need to pick three or four index funds in sensible proportions. The choice will depend on what’s available, but might mean putting most of your money in a fund that holds international stocks outside the UK, perhaps 10% in a UK fund and possibly even an extra 10%-20% in an emerging-market index fund (since emerging-market stocks tend to be left out of some global index funds) to get a balanced global portfolio. Then try to sit tight through the inevitable ups and downs.