What is a pension fund?

Saving for retirement is essential and it’s never too soon to start. Choosing a pension saving plan is smart way to ensure that you can retire in comfort and at a reasonable age.

There are many ways to save for your pension – you might keep a property portfolio, collect assets, or rely on your cash savings and stocks and shares earnings. But the most efficient way is to invest through a dedicated pension fund.

What is a pension fund?

Pension funds are pools of money managed by a group of investment experts, with the aim of generating positive returns for investors so that they can use the money after their retirement.

Investors usually set up a standing order to send money into their chosen fund every month. If you’re employed, your employer will likely be doing this for you, with any pension savings automatically deducted from your paycheck.

Your pension fund is separate to your state pension. A state pension is a fixed amount of money that is given to citizens to help them meet the cost of living after they have left the workforce. If you want to spend your retirement years in comfort, this may not be enough. As a result, many people choose to put their own money into a pension pot so that they can supplement their state pension when the time comes.

How do they work?

Most pension funds are run on the behalf of businesses or groups of businesses, and receive contributions from the employer and employees on a monthly basis. These contributions are then invested and any returns on the investment help to fund monthly pension payments to retirees. The amount of money that you receive in retirement will depend on two things: the amount of money that you have paid into the pension fund; and the value of the returns that your money has made.

Because pension funds involve long-term investing, they can make great use of compound interest to maximise returns. This means reinvesting the interest accrued on any contributions, so that you can effectively earn interest on your interest. Compounding can really add up over time, even if your annual returns are relatively small. And the earlier you start, the more you can potentially earn.

How to choose a pension fund

If you’re employed in the public or private sector, the chances are your employer will already be paying into a pension on your behalf. However, you may still be given a shortlist of pension funds to choose from.

When choosing a pension fund, it’s important to take a little time to do your due diligence on the fund. Look at their track record to get a sense of the volatility of the fund’s performance over the years. Pay special attention to tricky years such as the 2008 global financial crisis and the 2020 Covid-19 pandemic – you can expect to see a dip in performance around these times, but ideally there will be evidence of a quick return to form in the year or two after.

If you notice that returns tend to soar one year and nosedive the next, that could indicate that there are some issues at play. While past performance is no guarantee of future returns, investors like to see some evidence that the fund can generate relatively consistent annual returns over a prolonged period.

Next, look at the management team. These are the people you’re trusting to take care of your life savings, so you want to be sure that they are up to the job. Pension fund managers should be experienced in their area of expertise, so do a quick LinkedIn or Google check on them and make sure you’re comfortable with them.

Now, look at how the pension money will be invested. You will likely be shown a range of pension plan options based around different investing principles (for instance, ethical investing); different risk profiles; and the preferred makeup of your portfolio (for example, equities, bonds, etc). Choose the fund or funds that you’re most interested in and read through the fund fact sheet to learn more about which companies, countries and assets the fund is exposed to.

Modern pension funds often rely on broad-market index investing to deliver market-hugging returns over time. These funds are cheaper to manage and hold and strip out the risk of an individual’s bias affecting returns over time. Some of these funds let you choose the underlying indices within a certain legal framework. These are excellent for investors who don’t feel comfortable leaving a decision that big in the hands of a stranger.

Beware the fees

Pension funds are a wonderful compounding tool because we generally hold on to our funds for the duration of a career. However, sometimes we forget that fees compound too. Remember, you must deduct the management fee from the performance of the fund to get to the true returns in your portfolio. Keep a close eye on how much is deducted from your pension fund each quarter in fees.

Claiming your pension

When you’re ready and eligible to receive your pension, you will be given two options:

An annuity

This is a monthly payment which is covered by the interest payments on your pension fund, or a combination of capital plus interest.

A lump sum payment

This is when the entirety of your pension fund is given to you all at once – both the capital and any interest accrued.

Many people prefer the annuity as it acts as a salary replacement. There is also a very high chance that you will drop down a tax bracket after retirement, which lowers your tax burden and means you get to keep more of your money as a retiree.

However, the lump sum payment can be an attractive option if you have multiple pension funds, or if you want to reinvest your pension savings, or use them to make a dream purchase. Any lump sum payment will also be subject to taxation, but with more favourable terms if it’s classed as pension funds.