Understanding where pension funds invest is vitally important, especially when it comes to your own pension, as it allows you to understand what type of risk you are taking.
Your pension investment options will depend on the type of pension you have.
Getting the right mix of investments will grow your pension funds far greater over the long term than trying to pick individual winners.
Where pension funds invest will depend on what pension you have
Defined benefit pensions
If you have a defined benefit (also known as a final salary) pension then you will have very little choice in where pension funds invest. What you get at retirement is not linked to investment performance but based on the scheme formula which will take into account your salary, length of service and an accrual rate.
Behind the scenes the scheme trustees and administrators will make decisions on where pension funds invest.
You may be able to influence their decision by appealing to them, particularly if the pension scheme is small.
Defined contribution pensions
Nowadays most people will be building defined contribution pensions whether privately or through their employment.
There are different types of defined contribution pensions and again this will determine where pension funds invest.
Workplace pensions including stakeholder pensions and group personal pensions will tend to have limited investment options.
You can usually only purchase units in funds that are run by the pension provider themselves.
An investment fund, usually known as an Open Ended Investment Company (OEIC) or Unit Trust is a bit like a company listed on the stock market. But instead of having just one business a fund will invest into lots of different companies operating lots of different businesses.
The investment fund will be managed by a fund manager and each fund manager will operate a different strategy. For example some may focus on just UK companies, some on US companies. Some may focus on different sectors like technology or utilities.
An investment fund is a great way to reduce risk because you are effectively spreading your money amongst lots of different companies rather than investing into one company where there is the chance that company could go bust.
If you own a private pension like a Self Invested Personal Pension (SIPP) then you will have far more choices where pension funds invest.
You could purchase:
- Individual shares in single companies listed on a stock market.
- Units in investment funds like OEICS and Unit Trusts from the whole of the market.
- Deposit accounts.
- Commercial property (depending on the provider).
There is no automatic best solution when it comes to what type of pension you should have, only what is right for you.
Why choosing where pension funds invest is so important
In 1986 a famous study was done by Brinson, Hood and Beebower and published in the Financial Analyst Journal.
The study analysed what drives investment portfolio performance. Essentially they found 3 main factors:
- Asset allocation 91.5%
- Individual stock picking 4.6%
- Timing of the trade 1.8%
- Other factors 2.1%
The type of investment and how much you allocate to each investment (asset allocation) has by far the biggest impact on what level of performance you will achieve.
This is why it is so important to focus on this.
This analysis has been re-worked again and again over the years and the result is the same.
Forget about trying to find the best company out there to invest in or trying to time the market. Asset allocation is the key.
In order to choose the right investment mix you need to consider
- Your objective – how much do you need?
- Your required return – to achieve your objectives.
- Your attitude to risk – how much risk are you prepared to take to achieve your objective?
When working with clients we go through this process and have built a range of investment portfolios that are suitable for different risk levels.
Each portfolio uses evidence based investing. Meaning we don’t focus on what just so happens to be working now, we focus on what always works based on years and years of evidence from Nobel Prize winning economists.
Want to find out more about where pension funds invest? Just get in touch and book a no-obligation free 15-minute call.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.