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How does the stock market affect your pension?

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We have all seen the financial small print on financial products – be that on TV, the internet or in our local bank branches – that says ‘the value of your investment may go down as well as up’. And depending on the type of pension you have, that could be especially true.

If you’re one of the lucky million or so workers to still be an active member of a defined benefit pension scheme (often called a final salary scheme), then the various movements of the stock markets don’t have too much of a direct effect on your retirement income.

While they will affect the scheme’s funding status – which could cause the sponsoring employer to make payments to top up the scheme should there be a shortfall – your retirement income is based on your income at or towards the end of your working life, or how long you were with your employer, and the scheme will usually be obliged to pay this.

Market exposure

But for the millions of workers in defined contribution (DC) schemes (also often known as money purchase), market movements are of paramount importance.

For many DC scheme members, the majority of their savings are invested in the stock markets, and their eventual retirement income depends on how these investments grow over time.

It’s not uncommon for as much as 100% of the money you save in your pension to be invested in stock markets, although in many cases your savings will also be invested across other types of assets, including corporate and government bonds (debt), property (usually office blocks and buildings like shopping centres) and even hedge funds.

Your stock market investments will usually be split between UK stock markets, such as the FTSE 100 and/or FTSE 250, and global market indices, such as the MSCI World index.

DC funds often have a stated investment goal like “to provide a good return through a combination of capital growth and investment income”. This means they look to grow your money through both the share price rising – capital growth – and by reinvesting any dividends into the fund – investment income.

Hold the course

Of course, as the investment small-print says, markets can and do go down as well as up, as anyone who lived through the financial crisis will be only too well-aware. The FTSE 100 fell to a low of around 3500 in March 2009 – from its long term average of around 6,000 – causing a lot of investors to take flight and take their money out.

You may be tempted to do the same and stop saving in a pension in such circumstances, but investment theory suggests otherwise.

When the stock market is low – and assuming that it will rise again in the future – the money you save buys comparatively ‘more’ investment than when the market is higher and therefore goes some way to compensate for comparatively more ‘expensive’ saving at other times.

This is a concept called ‘pound cost averaging’ – think of it as akin to buying something you buy regularly when its in the sales or on offer, which reduces or smoothes out the average per unit cost.

A lifestyle choice 

Over time, as you approach retirement age, the amount of your pension savings that are invested in the stock markets will usually be reduced in favour of investments in other assets that are seen as less ‘risky’, such as government debt and cash.

This process is often known as ‘lifestyling’ as it takes your changing needs into account, and normally starts to take place in the 5-10 years before you retire.

Your pension manager will either have set dates or market milestones to meet when shifting your money – e.g. they will reduce what you have in the market on such a date, or when the market hits a certain level.

When making any decision about your finances, if you haven’t already, it could be worthwhile seeking financial advice.

This article has been commissioned by retiresavvy and any opinions voiced are the author's own.

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