Taking a degree of investment risk, alongside paying in regularly, is the bedrock of building up a pension pot. Depending on the age at which you start saving in a pension, the majority of your money may be invested in the stock markets.
What is ‘investment risk’?
‘Risk’ is a term used by investment professionals to describe the uncertainty that an asset or investment, such as putting money in the stock market, has in its potential to make a profit.
Although there are many complex mathematical formulae for calculating investment risk, a general rule of thumb is that the more investment risk you take, the higher the potential returns – and the higher your chances of losing your money.
How much risk you take is determined by your investment choice. Almost all pension schemes have a default fund, which the vast majority of savers (in some cases, as many as 99%) normally end up in.
How does risk affect my savings – and when should I take risk?
If you are earlier in your career, or a long way off your retirement age, then your pension fund is likely to be exposed to more risk – that is, invested in higher risk assets – than if you are older. This is because your ability to absorb risk (e.g. make up for any falls in value as a result of poor investments) is greater when you’re young – you have longer saving and investing ahead of you.
As well as stock market investments, you will also likely be invested in other types of assets, which have their own level of risk, such as bonds (debt), property (usually office blocks and buildings like shopping centres) and even hedge funds.
Default funds are usually designed to make a trade-off between taking enough risk to provide growth, but not so much that there’s a high chance of members making massive losses as they come to retire.
A lot of pension providers also offer higher and lower risk investment options for members who want to make their fund choice, although they have to be aware of the potential consequences, and typically, very few people ever take up this option.
Risk as you approach retirement
As you head to retirement age, your overall mix of your investments in your pension pot will usually start to change, with the amount of money invested in the stock markets reduced in favour of less ‘risky’ investments. Typically, these will be a mixture of government and corporate bonds and cash.
This process – known as ‘lifestyling’ – is designed to reduce risk and consolidate your savings in the run-up to retirement, and normally starts to take place in the 5-10 years before your retirement date. However, while lifestyling is designed to reduce risk, it doesn’t protect you from major maket movements. In addition, if gilt markets (government bonds) fall, the value of your pension will also decrease.
Risk and the new pension rules
But with the new reforms coming in from April, which will allow retirees far greater freedom in how they access their pension pots, there are questions about how much risk will be appropriate.
As retirees will no longer be required to buy an annuity with their savings but instead will be able to withdraw the money over time, the need to consolidate as large and as stable a pool of cash as possible may become less relevant.
If you are in a lifestyle fund, the risk level will automatically reduce, but if you plan to keep your pension fund invested, this might not be right for you. It may be more appropriate for some retirees to keep some of their pension pot invested in ‘risky’ assets, like stocks and shares, which will keep generating income over time and potentially continue to grow your pot .
This article has been commissioned by retiresavvy and any opinions voiced are the author's own.
Back to 'Pensions explained'