The dangers of neglecting your pension

When did you last review your retirement savings? You'll be shocked at how much pensions plummeted during the Noughties...

What's the most important financial decision that you'll ever make? Buying your own home? Possibly. Finding a better-paid job? Perhaps. Choosing a spouse? That's definitely a biggie.

However, to me, the most important financial decision most people face is how to fund their retirement. Indeed, your biggest asset later in life may be your pension, not your home. For example, you could retire at 65 with a mortgage-free home worth, say, £300,000, but with a pension pot worth perhaps twice as much.

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The collapse in personal pensions

The big problem for most workers is that they find pensions and retirement planning boring. Hence, they don't put much effort into it or keeping an eye on their pensions. Alas, ignoring this big issue can be a major disaster, as the following table shows:

Source: Moneyfacts, February 2010

The second column of the above table shows the value of a pension maturing on 1 January 2000 and at the start of this year. These two pots were each built up over 20 years by contributions of £100 a month, with a total investment of £24,000 apiece.

As you can see, there's a vast difference between the two payouts. The Eighties and Nineties were bumper decades for stock-market investors. Thus, the 2000 payout was almost £104,000, with a gain of almost £80,000. Alas, the Noughties was the worst decade for investors in living memory. Hence, the 2010 pension pot was valued under £40,800, with a gain of less than £16,800.

Unfortunately, that's not the end of the story, as my third column shows. During the past decade, interest rates have plunged, with the Bank of England's base rate currently at a 316-year low of 0.5%. This has brought down the yield (interest paid) on UK government bonds, to which pension income from annuities is linked.

In addition, longer lifespans have reduced the amount insurance companies are willing to pay for an annuity (the income bought using a pension pot which is payable until death). Therefore, in 2000, a 65-year-old man could buy a yearly annuity worth 8.66% of his pension pot. In 2010, this yield had fallen to 6.24%, which is almost three-tenths (28%) less.

Put together, these three factors - lower investment returns, lower annuity rates, plus rising longevity - add up to a pensions H-bomb. The income paid to our 2010 pensioner is just over £2,500, versus almost £9,000 for the 2000 pensioner. This amounts to a disastrous collapse in pension income of almost three-quarters (72%). Yikes!

The danger of default pensions

One reason why the typical personal pension has performed so poorly is that so many of us have invested our money in 'balanced managed pension funds'. Usually, these funds are the default option for personal and company pensions. Thus, workers who don't wish to make their own investment choices are often automatically enrolled into balanced managed funds.

Balanced managed funds can invest in a wide range of assets, including equities (shares), property, government and company bonds, cash, etc. Then again, some of these funds often have very high exposure to equities. Indeed, some funds put up to 85% of their money in shares, which may not meet the needs of cautious retirement savers.

So, balanced managed funds are not all the same - indeed, they may have very different investment approaches, charges and returns. That's why I'm not a big fan of these default pensions, as there's no such thing as a 'one size fits all' strategy for all savers.

Your pension should be dynamic, not static

With pensions, you really need to know what you're buying, so don't put your hard-earned wage into a balanced managed fund without first doing your homework.

Before signing on the dotted line, ask for details of the fund's asset allocation (where it invests your money), charges, previous performance, and the manager's investment strategy. If you're unhappy with any aspect of the fund, then look for a more suitable home for your contributions. Otherwise, choosing the wrong pension fund could be nearly as bad as making no pension arrangements at all.

In addition, pensions are not "fire and forget" investments. Given that you may be paying into a pension for 40 years or more, your strategy should change over time. Indeed, keep an eagle eye on your pension, as dragging your feet could cost you plenty later down the line. Ideally, you should review your pension arrangements on an ongoing basis, say, once every six to 12 months.

My advice is simple: treat your pension as a dynamic - and not a static - investment. At certain times, you may need to increase your contributions, perhaps as a response to falling investment returns. Likewise, you may decide to ramp up your exposure to shares in your early years, but cut back on risky investments as you near retirement. (Some funds have a 'lifestyling' option which does this for you automatically.)

By keeping an eye on your pension pot, and altering where you invest in order to suit your personal outlook, you stand a much better chance of being prepared for life after work. Otherwise, you face an uphill battle in your fight to fund a comfortable retirement.

Lastly, watch out for fund charges, because the higher the charges, the lower your investment returns (all other things being equal). Indeed, a fund growing at 6% a year after charges will produce a return of 929% over 40 years. However, a fund growing at 7.5% after charges will grow by 1,704% to produce a pot almost twice as large.

Therefore, the lower the charges, the better your changes of building a decent pension - which is why I'm a big fan of cheap, simple tracker funds.

If you have any questions about boosting your retirement income, then check out our Q&A for help. Also, view the pension and annuity questions to see what other lovemoney.com readers are talking about.

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