A Little Bit Richer

Kia: Hey, it’s Kia. We’ve talked a lot on this podcast about the importance of workplace pensions. Kim Brown did two great episodes with me on getting to grips with your workplace pension and why they matter so much. But today, we're diving deeper into how your pension is invested.

If you've been saving into your workplace pension and wondering about its performance, this is the episode for you. So what does your dream retirement look like? Holidays twice a year, being completely mortgage free, or having the money to pay for your grandkids' education? Well, however your ideal retirement looks, knowing where your money is invested and how it's growing for you is going to be crucial.

Welcome to another episode of A Little Bit Richer, brought to you by my friends at Legal & General. Today, we have another expert from Legal & General, Michael Porter. Michael heads up the Workplace Pension Product Team at Legal & General, so he's the right man to explain more on how pension savings are invested, changes you can make, and how investment risk is defined. Welcome, Michael.

Michael: Thank you, Kia. Nice to be here.

Kia: I'm really excited to have you here and talk about one of my favourite topics ever, pensions. So first things first, can you explain more about how your pension savings are actually invested?

Michael: Absolutely. So the first thing to understand is that your pension savings are invested, as you say in your question. Your pension savings aren't held in a bank account or a cash savings account, so where it gathers interest and the value tends to go up and not down.

Pension savings are pooled together with other pension saver money, and they then are invested into something called an investment fund, which buy and sell different types of investments, which I'll come on to explain later. But the value of those can go up and down.

Kia: I think when it comes to pensions, they're such a great tool when it comes to planning for your retirement and having that money stored there, but it can be quite confusing. So I'm glad that you broke it down for us. But let's get a bit deeper then.

So can you talk a bit more about investment risk and what that actually means? Because I think when we talk about investments and pensions, retirement, you want to make sure that you've got that secure cushion there. So when you hear the word risk, you get a bit scared, but what does that actually mean?

Michael: So the first thing to note is that there are different types of investments that your pension savings might buy. There are equities, bonds, property, cash, or a combination of those. Now equities are where your money gets put to good work by investing into companies, and those are typically listed on a stock exchange, and the value of those companies goes up and down depending on how they perform. Then you've got bonds.

Bonds are basically companies or governments that are taking out a loan, and with that loan, they pay interest on the amount of money that is being borrowed, and then at the end of that loan, once it matures, they pay back the original amount of that loan. You then have property. Property is investing into commercial real estate or commercial properties. So that might be a factory, a commercial unit, it could be an office block.

And when an investment fund purchases one of these types of properties, the value of that property goes up and down.

But also, those properties tend to be let out and then they receive rental income, which all goes towards helping your savings grow. Then you have cash, and cash isn't physically held cash, so it's not like cash under a mattress. It's held on something called overnight deposit. Now that might be with a financial institution or it might be with the government, and they tend to be a bit more secure. They're not guaranteed to not go down, but they are a bit more secure.

And then you have a combination. So some investment funds might not be specific to one of those types of investments. They might hold multiple investment types, and those tend to be called multi- asset funds or diversified funds, diversified growth funds.

Then risk. Different investments have different levels of risk. So basically what risk means is it's the likelihood that the value of your pension savings might go down. Now they go up and down all the time, but in the shorter term, it's all about how likely is your money going to go down the following day or that particular day, and that's what we call volatility.

So one of the benefits of having a pension is that your monthly savings go into buying these investments. Now, you might have heard of something called pound cost averaging. What this basically means is drip- feeding your money into pension savings, and some months you'll be buying investments when they're lower, sometimes you'll be buying investments when it's higher. This smooths out your investment experience and reduces the level of risk attributed to your funds, but ultimately, it averages out and it reduces the amount of risk that your pension savings have.

You can think about it a little bit like British weather, particularly in summertime, when there might be dry days, there might be wet, rainy, cold days. But if you look back across history, typically, summer tends to be warmer, hotter, and drier more often than not. So that's the benefit of pound cost averaging. So sometimes your money might go in and you're buying investments at higher cost, sometimes you'll be buying them at a lower cost, but ultimately it averages out and it reduces the amount of risk that your pension savings have.

Kia: So that is a good thing to note there. So thank you for telling us about that. You've done a really good job at breaking down the different assets that can come with an investment fund. So can you explain to us a bit more when it comes to workplace pension, where are our savings usually invested?

Michael: So your savings are automatically invested somewhere. So that tends to be called a default fund, or you might also see it referred to as a default investment option. Now, there are different types of default investment options. It might be a single fund or it might be a combination of different types of funds that leads to an investment strategy. So you have somebody that's there managing your funds and your investments on your behalf.

So you've got the safety and comfort in knowing that your pension is invested by an expert. It's managed and it's looked after. It's not guaranteed in terms of it may still go down because in investments markets, you do get turbulence and you do get volatility in the shorter term. But over the longer term, equities, for example, they've proven typically to outperform cash savings accounts.

Kia: So when it comes to your pension, especially the workplace pension, is it best to leave the investing decisions to the experts and use the default fund that your pension company offers?

Michael: So, generally, default funds are most appropriate for the majority of investors. However, if you do want to take that little bit of extra risk, there are different investment options available for you, and the best way to find out what they are is by going onto your pension account online, or you might actually have received an investment guide or an investment brochure, which will tell you exactly the different types of investments that are available to you.

So firstly, you want to really check, does this default fund really meet my needs in terms of my expected retirement outcomes, my level of risk and my attitude towards risk, or should I choose my own investments?

One of the most important things to say though is if you do go ahead and choose your own investments, it's a bit like you are now on your own. So those investments don't change throughout time. If you choose to be, say, a hundred percent invested into one of those equity funds that we talked about where it's buying money in companies across the world, then it will stay invested in that fund until you review it or until you make an investment change.

Kia: That's a really good point that you make there. I think, yeah, if you make that change, now you've kind of committed to being hands- on to your pension until you get to the point where you draw down on it. We've touched on it a bit because you explain the different types of assets that are available, but can you, just for our listeners, explain diversification in simple terms?

Because we hear diversifying your risk, diversifying your investments, but can you explain it in simple terms and what this means for not just your pension, but also other savings as well?

Michael: Definitely. So diversification, in its simplest terms, is not putting all of your eggs into one basket, so not going all in on equities or all in into a bond fund. So if you think about it a bit like going to a buffet, so actually at a buffet you would go and try a few different types of food, and the chances are then that if there's one part of that meal that you don't like, then there are going to be other options available to you that you will like, ultimately.

So that's the first thing. And the other thing I would say is that you should probably have a balanced diet as well. So not just all about pension savings, you probably want to diversify where your savings are invested, because they all serve a different purpose. So pensions for example, saving into a pension is going to help you towards saving for retirement. But then if you've got medium- term savings goals, you might want to invest in something like a stocks and shares ISA, or have a cash ISA.

Kia: Michael, you are the expert that we needed for this to break it down. We're going a bit further now. We hear the words active and passive, and whenever I think about it in non- financial terms, I'm thinking about if I'm in the gym, I'm active, if I'm sitting at home on a sofa, I'm passive. But these have slightly different meanings when it comes to investments. So what's the difference between a fund that's actively managed versus one that's passively managed?

Michael: So an active fund is where you have a fund manager that is actively looking to find different investment types or investment opportunities. So they would go out and they would research companies. So if you're talking about an equity fund, they'd go out and research the companies and then identify those that they want to put into their investment fund.

So for a passive fund, that's where an investment manager or a fund manager would invest into every company that is listed on a particular stock exchange or within an index. So if you invest in a UK equity index fund, let's say, the index is the FTSE All- Share. Now that is made up of the top 600 companies within the London Stock Exchange, which is about 2000 companies.

What your passive fund tries to do is it tries to match the performance of all of those companies. So it will hold those companies based on their relative value, and then you'll see your fund go up and down depending on how all of those companies in combination perform.

So active funds tend to hold less companies or less investments, which might mean that it has a greater amount of risk that we talked about because it's less diversified, but a passive fund, because it would hold more of those companies or investments, it will be potentially less risky. But that's not to say that it wouldn't go down in value.

Kia: I'm interested then, off the back of that, or the active fund, because there is someone who's actively going out there and researching, is there a difference between the two funds, for example, maybe in the fees because you have someone who's actively working on that?

Michael: So active funds tend to hold a bit more of an investment cost to them. So there are fees that are charged as a result of it, which it's either called an investment management charge or a fund management charge, because they are having to go out, meet with companies, they're having to do their investment research, they have analysts that do all of the investigation and research, whereas a passive fund, there's much more automation that's involved.

So as it tries to track the performance of companies, it will buy and sell those companies based on how they perform on a daily basis, which is far more automated, and as a result, they tend to be a bit cheaper.

Kia: Okay, that's good to know. Thank you so much. When you're looking at your pension savings and investments, can you see which companies your money's actually invested in? Can you see the breakdown or is it more of like an overview of where your money is?

Michael: So the first thing you probably want to do is log into your pension account online. That's if your pension provider or your pension scheme has that facility available. If you don't know who your pension provider is, the best thing to do is go and speak to your HR department and they will point you in the right direction. But once you've been able to register and you've got access online, you can then see where your money is invested.

So what's the default fund that it holds? Typically, there's also an investment guide that comes alongside your pension. So you want to have a read of that pension guide or the investment guide to find out what's the investment strategy.

Once you've identified that, if you want to even delve a little bit deeper and really find out whereabouts your pension savings are invested, pension schemes tend to offer something called a fund fact sheet. And a fund fact sheet is basically just telling you what's the name of the fund, what's its objective, where is it invested, how is it performed, what's its level of risk as well, and you might even get to see the top 10 holdings of a fund.

So it might be invested in the top 10 companies within the FTSE 100, for example. Also, the other thing to note is that if you're invested in one of these passive funds, the chances are you're going to be invested in all of those companies that will be held within that index.

Kia: That's good to know. So Michael, the stock market has seen a dramatic ride in recent years, so should people be worried that their pension savings won't grow very well, or that it might be better to save their money in a savings account or a cash ISA?

Michael: The last few years, we've seen quite a lot of market turbulence, as we would call it. So that's where investment markets have gone up and down. Now that's been as a result of Brexit. We've had the Russian war in Ukraine. We've had a lot of political uncertainty, and also COVID as well. So these have been unprecedented times, really. But the main thing to note is that your pension savings, they're a long- term investment, so you're investing for a long time, over 30, 40 years. So it's important that you don't make any rash decisions.

You might expect to see your pension savings go down in the short term, but history shows us that over the long term, they tend to do quite well from a performance perspective. But again, not guaranteed, can still go down and you might actually get back less than you put in, but typically, they will grow.

Kia: When it comes to fees and charges, I know we touched on it a little bit, but what are the fees and charges that we can expect on pension savings, and how do they differ across different fund types?

Michael: There are lots of different types of fees, and they might be charged in different ways, but typically the two main ones are investment fees that we talked about earlier, or a fund management charges, and then there's also an administration fee. So this is the cost of the operational servicing of your pension scheme as you change your address or whatever it might be that you're getting in touch with your pension administrator for.

Investment charges can differ between investment types as well. So the active funds that we talked about earlier, they can tend to be slightly more expensive. Passive funds can be slightly cheaper, and they also differ across different investment types. There are some other charges. You have something called additional fund expenses and transaction costs. It's important that you know that these aren't charged by the pension scheme provider or by the fund manager. They're the cost of buying and selling the investments.

So it's important that you don't frequently switch funds. So when we talked about earlier, can you choose a different investment from the default? Yes, you absolutely can, but you incur a cost as a result of switching, and frequently switching is going to eventually reduce the amount of money that you have at the end when you come to retire.

And an example of that is like baking a cake. So if you go to bake a cake and you're constantly opening the oven door, you're letting some of that hot air out and it might not rise as much as you might expect. So keep that door closed, let the oven do its thing, and then you can experience what the cake is like once you open it and the time finishes.

But it is important to say that different ovens, so if we think about ovens as the investment types, different ovens would cook at different speeds and you might get a different outcome each time, and you're not always guaranteed to get back what you put in.

Kia: Michael, you have some of the best analogies that I've come across when it comes to explaining difficult financial jargon. Keep going. I always want to just ask you more questions so you can give me more analogies. That is great.

Michael: I've got more.

Kia: I know you've got them loaded up. It was good. But before we end this episode, because you've shared so many amazing tips, can you share our listeners your top three tips on workplace pension investments?

Michael: Yep, absolutely. So it's important to remember that pensions are a long- term investment. Don't make any rash decisions. You might expect to see it go up and down, so don't react based on short- term changes. Secondly, the sooner you start saving, the more time that you give for your investments to grow, and it's important that you start early.

And then finally, can you save a little bit more? So are you making the most of that employer matching contribution? Can you add a little bit extra in? Or as you get a salary increase, maybe you might be lucky enough to get a pay rise, could you put a little bit of that towards your pension savings? Ultimately, putting a little bit more aside today or sacrificing a little bit today will only benefit you when you come to retiring.

Kia: Michael, thank you so much for coming onto the podcast. You have been incredible breaking down workplace pensions in such simple terms for us to understand. Between your episode and the two episodes with Kim, I think we have got pensions down to a tee. So thank you so, so much.

Michael: Thanks.

Kia: There's lots of useful information to help us get engaged and grow our workplace pension. Next time, we're talking all about parenting and finances with Charlotte Jessop from Looking After Your Pennies. I'd love it if you could review the podcast, spread the word, and help others get a little bit richer too. Keep up with the show on TikTok and Instagram at Legal & General. Thank you for listening. See you soon.