Are Pensions Too Risky?

There's only one person who can reduce the risk of your pensions ending in disaster. Can you guess who it is yet? Here are some tips.

There have been plenty of financial disasters and scandals. I'm not talking about British Rail, British Steel, Concorde or the NHS! I'm talking more recent decades, and issues that concern us directly. Such things as the endowment mis-selling scandal, the property-market crash and the dot-com bubble .

Of all the financial disasters that have happened in the last few years, possibly the worst is the pensions crisis and, in particular, under-funded pension funds, which have resulted in many people receiving pensions that are a fraction of the size they expected. These people spent decades working and paying into a pension just to find the money stolen by their employer and the government. (He said melodramatically - but accurately.)

Consider also that some people have paid in extra to top up their state pensions and now recent changes to improve the state pension for all may mean that they have wasted those extra contributions.

But we can't dwell on the past. (Although we can support people who get virtually no pension despite government promises of protection! Add your name to the petition at www.petitiononline.com/pensions/petition.html) Let's look now to ourselves and at future risks to our own pensions.

Those affected by under-funded funds were in defined benefit schemes. Although some of these schemes are still around, they are dwindling, so I won't cover them here. I want to now consider the pension risks to what I think of as modern-day pensions: defined contribution schemes. With these, money you contribute is invested, usually in shares, property or bonds. What you get out of it depends on how your investments perform.

The risks to these pensions are simple and few in number, but potentially devastating. These are:

• you fail to contribute enough;
  
  
• the investments don't perform well enough;
  
  
• the government changes the way personal pensions are taxed or increases the tax rates;
  
  
• the government changes other personal pension rules; and
  
  
• the government changes state pension rules or how our National Insurance contributions affect the amount of state pension we receive.

Pension companies can also go bust, but the risk is minimal for defined contribution schemes, especially now we have the Pension Protection Fund, so I haven't included this in my risks list.

Still, with all the lost income and broken promises, why should we bother risking investing in our futures? Simply because we have to. The only person we can trust to reduce these risks and provide for our futures is ourselves. With this in mind, here are three things you could do to protect your retirement pot as best as possible against future disasters:

1. Increase your contributions and benefit from compounding

Contribute more to your pension. It sounds obvious, but you need to see for yourself the affect increasing your contributions might have. To do this, play around with the pensions calculator. Furthermore, the earlier you contribute, the better. Read about the effects of compounding: they are astounding!

2. Use an index tracker

Choose your fund carefully. You can't just increase your contributions and expect your fund to do well. Each pension scheme usually offers a dozen or more funds to choose from. The Foolish favourites are funds called 'index trackers', which consistently outperform most other funds simply by tracking how stock-market indices (such as the FTSE 100 or FTSE All-Share) are performing.

The reasons for their success are that they are very cheap (high fees can eat significantly into your pension pot) and they are consistent. All other types of funds charge a lot more and they rely on stupid humans you've never met to select investments for you. And even if you chance upon a good fund manager, he might leave a month later and be replaced by an idiot. (No, I'm not bitter! I've never trusted strangers with my money!)

Read more about them in Index Trackers Vs Managed Funds.

3. Spread the risks using different investments

There is little you can do to reduce risks to the state pension; for that we are reliant on the government, and all future governments, to keep their promises. However, you should consider the state pension as a useful hedge in case your personal pension fund fails.

You can further spread the risk by using other investments, such as ISAs. This way, if the rules change against you for pensions, at least, perhaps, ISAs will be safe. Consider the pros and cons in Pensions vs ISAs.

> Take a look at some Foolish index-tracking ISAs.