17 million Brits make this mistake

Find out why you could be making a huge error with your most important financial asset - and how to make sure you stop.

According to research by Baring Asset Management, almost 17 million working people in Britain (48%) have never ever reviewed their pension plans. So, for example, these people set up a pension in their twenties, faithfully contributed every month but ignored what was happening to their money for the next forty years or so.

Crazy, isn’t it? You can clearly see why there’s a good chance you’ll end up with a less than healthy pension pot given decades and decades of neglect.

It’s a rather worrying statistic that just one in five people (21%) have revisited their pension plans in the last year. Personally, I think we should all make a point of investigating how well our pensions are performing at least once every 12 months. How else will you know if your retirement planning has gone awry?

The default option

But it also concerns me that of those who have reviewed their pension plans, 38% - that’s almost 7 million pension savers - chose to invest all their pension contributions in the ‘default option’ fund.

All pension schemes offer a default option fund which your savings will be automatically directed into unless you take the time to choose your own investment funds.

This only applies to what’s known as ‘defined contribution’ pension schemes, such as ordinary personal pensions. With this type of pension arrangement, the final value of the plan at retirement, and the benefits you can take from it, are unknowns. It’s down to you to decide where your pension will be invested (within the parameters set by the scheme in question) in the hope of achieving strong returns over the long-term. If you don’t make any investment decisions, your contributions will simply be paid into the default option chosen by the pension provider instead.

But default options don’t apply to ‘defined benefit’ pensions, such as final salary schemes. Members of defined benefit schemes aren’t required to make any investment choices since the benefits received in retirement are linked to the member’s salary. It’s the responsibility of the company that offers the scheme to invest it in such a way that guaranteed benefits can be paid to retired employees now and in the future. (At least, that’s how final salary schemes work in theory, but we all know the reality has been very different.)

What’s wrong with the default option?

Perhaps you’re wondering what’s so wrong with the default option. The trouble is the default investment fund or strategy is normally a very middle-of-the-road option which isn’t likely to produce sparkling returns over the long-term.

All investment funds are classified into different sectors, and most default options fall into the ‘Balanced Managed’ sector. This means the fund can invest no more than 85% of its assets in equities (shares), which can temper growth.

The default option is supposed to represent a sensible investment strategy for the average pension saver. But this can lead to decidedly average performance, if not worse. After all, it's well-known in the industry that the default balanced managed funds offered by many of the large insurers have had far less than impressive track records.

How can you do better?

Over the last five years, the average Balanced Managed fund has returned less than 21%, but I think you can do better than that. A more proactive approach can pay really pay off if your pension is invested well.

Of course, some savers don’t have the inclination for the job. This is fine as long as they consult an independent financial adviser for help instead. But if you’re prepared to take on the task yourself, there are certain key considerations you should think about.

First of all, despite being a poor choice in many cases, not all default funds are bad. If the fund meets your investment objectives and has performed strongly over different timescales, it may be a perfectly suitable option.

Your pension scheme will likely have a range of investment choices on offer which you should investigate, in addition to the default fund. If you can invest in more than one fund, it’s sensible to do so to avoid keeping all your eggs in one basket. Don’t forget, the entire fund range available under your particular scheme is at your disposal.

But what should you look out for? Aim to do the following:

• Choose funds which have strong performance track records over different timescales, and have performed well against their individual benchmarks.
• Check the initial and annual management charges for each fund. Unnecessarily high costs will drag performance down.
• Find out who manages the fund and whether they are successful in achieving the fund’s investment objectives. Most funds are rated by various ratings agencies. A good place to check this out is the TrustNet website which provides fund ratings from Standard & Poor’s, OBSR and Financial Express Crown Ratings.
• You can also find out where each fund is invested in terms of shares holdings, geographical weightings and sector weightings.

Diversify, diversify, diversify

Once you've chosen a range of funds, it's important to check they're well balanced. For example, it's a good idea to avoid investing solely in the UK shares. An over-reliance will become obvious if, and when, the UK stock market collapses.

By mixing and matching funds you can gain exposure to different types of assets, geographies and markets to help achieve a balanced pension portfolio. But, of course, putting together a robust investment strategy can be a complex exercise. Before you review your plan, take a look at How to successfully diversify your portfolio. This article will explain how to manage risk by investing your pension in different assets. Good luck!

Tell us your tips

If you have any tips on how to successfully plan and invest for retirement, do share them with other lovemoney.com readers using the comments box below.

This is a classic article that has been updated for 2011.

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