How Pension Funds Actually Invest Your Money

How Pension Funds Actually Invest Your Money

Most people have no idea what their pension is invested in. They see a number on a statement once a year, possibly check whether it has gone up or down, and move on. Given that your pension is likely to be the largest pool of money you ever accumulate, that is worth changing.

To understand how your money is invested, you first need to understand what your pension fund is trying to do. You also need to appreciate that what it is trying to do changes over time. This means that what it is invested in will also change; your pension fund investments at age 22 will be very different to those at age 62.

To keep things simple there are two main stages: the growth stage when you are typically younger, and the income stage when you are closer to retirement and thinking about your options.

The growth stage: making your pot as large as possible

In the growth stage, the job of your pension fund is to grow as much as possible. This is when the power of compounding and investing in higher returning assets should be front and centre of mind, so that you can maximise the size of your pot at retirement.

So how do pension funds actually invest your money in the growth stage? This is typically focussed on a diversified portfolio of stocks, or company shares. As an owner of these companies you benefit from your share of the earnings these companies generate, which are either paid out through dividends or reinvested into the company to compound future growth even more.

A pension fund in the growth stage will not just own shares in one company or even one country. A well constructed portfolio spreads your money across hundreds or even thousands of companies, in the UK, the US, Europe, Asia and emerging markets. This is diversification in practice. If one company or one market has a bad year, the others help cushion the impact.

Within equities, there are further distinctions. Some funds focus on larger, established companies that pay regular dividends. Others tilt towards smaller, faster growing companies where the return potential is higher but so is the volatility. Most default pension funds hold a broad mix across both, weighted towards the global market.

Why stocks dominate the growth stage

With higher return however comes more risk, with the potential to see large changes in prices in the short term as buyers and sellers try to understand how much a company is worth. This is normally during times of higher economic uncertainty, where people begin to question how much growth these companies can really produce and investors demand lower prices to account for this uncertainty.

As a long run investor however this should not worry you. The short term fluctuations often end up being a very good buying opportunity for long run investors, and with a years or decades long time horizon for being invested the growth factor often ends up dwarfing these short term moves.

To put some numbers on it: over the past 50 years, a broad global equity portfolio has returned somewhere in the region of 7 to 10% per year on average before fees, depending on the exact index and time period. That compares to 3 to 5% for government bonds and even less for cash. Over a 30 or 40 year pension saving period, that difference in annual return translates to a dramatically larger pot at the end, which is why pension funds in the growth stage are so heavily weighted towards equities.

For a longer look at why this is the case, see Why Pensions Own So Many Stocks.

The income stage: protecting what you have built

As you get closer to and into retirement, what your pension fund is trying to do changes. You no longer have as much time to make back any shorter term losses, and you are likely thinking about what you want to do with the money at retirement.

As your pension fund's job changes the investments will also change. Once you get closer to retirement your pension fund typically holds less growth focussed investments such as stocks, and will have moved a significant amount of the money into bonds, or loans to governments or companies. While the potential growth and return is lower, there is also less risk that your pot will see large changes in valuation as the prices of bonds typically move around less than stocks.

What bonds actually are

When your pension fund buys a bond, it is lending money. If it buys a UK government bond (known as a gilt), it is lending money to the UK government. If it buys a corporate bond, it is lending to a company. In return, the borrower pays interest at regular intervals and repays the original amount at a set date in the future.

Some bonds are designed to pay a fixed interest or "coupon" at regular intervals, which are more appropriate for someone at the later stage of their pension journey who might want some income. This is one of the reasons bonds are favoured in the income stage. They provide a more predictable stream of payments, which aligns with what most people want from their pension once they stop working.

Bonds are not risk free. Their prices can fall if interest rates rise, and corporate bonds carry the additional risk that the company might not pay you back. But in general, bond prices move around less than equity prices, which is the key point for someone approaching retirement.

Beyond stocks and bonds

While equities and bonds make up the bulk of most pension fund portfolios, they are not the only things your money is invested in.

Property. Some pension funds hold commercial property, either directly or through pooled funds. This might include office buildings, warehouses, retail parks or residential developments. Property can provide a rental income stream and some diversification away from stock and bond markets, though it is less liquid, meaning it cannot be sold as quickly if the fund needs the money.

Infrastructure. This is a growing area for pension investment and one the government is actively encouraging. Infrastructure assets include things like toll roads, renewable energy projects, water utilities and social housing. They tend to produce steady, long term income streams that can be linked to inflation, which on paper makes them a good fit for pension funds with long time horizons. The challenge has historically been that these assets are hard to access, particularly for smaller defined contribution schemes.

Cash and money market instruments. Pension funds hold a small proportion in cash or near cash instruments, partly as a buffer and partly to manage day to day operations. This allocation tends to increase as the fund gets closer to its income stage.

Alternative investments. Some funds, particularly larger ones, invest in private equity (buying stakes in companies not listed on a stock exchange), commodities, or hedge fund strategies. These tend to be more common in institutional pension funds than in workplace defined contribution default funds, but the boundary is shifting.

The glide path: how your investments shift over time

The transition from growth stage to income stage does not happen overnight. Most workplace pension default funds use what is called a lifestyle strategy or glide path, where the investment mix gradually shifts over a period of years.

A typical glide path might work like this. In your twenties, thirties and into your forties, the fund holds 80% or more in equities with the rest in bonds and other assets. From around 10 to 15 years before your target retirement date, the fund begins to reduce the equity weighting and increase bonds and cash. By the time you reach retirement, the fund might be split roughly evenly between equities, bonds and cash, or tilted even more conservatively depending on the provider.

This happens automatically. You do not need to do anything, and most people in a workplace pension will be invested in a fund that works this way whether they know it or not.

The logic is sound. Holding more equities when you are young and have decades to ride out volatility makes sense. Gradually reducing that exposure as your retirement date approaches protects the value of what you have built from a badly timed market fall.

The limitation is that lifestyle strategies assume you will take your money at a fixed retirement date in a particular way. If you plan to use drawdown and stay invested through retirement rather than buy an annuity, a traditional lifestyle fund might move you out of equities too early. This is something worth understanding, particularly if your retirement plans do not fit the standard mould.

The default fund: what most people are in

If you have a workplace pension and have never made an active investment choice, your money is almost certainly in the scheme's default fund. This is not a criticism. Default funds exist because most people do not want to pick their own investments, and for most people they are a reasonable option.

A good default fund will be diversified across asset classes and geographies, use a glide path as described above, and charge a fee within the auto enrolment charge cap of 0.75% per year. Many default funds charge less than this.

The important thing is to know that you are in one, and to understand roughly what it does. Your pension provider should be able to tell you the fund name, what it is invested in, what fee it charges, and how it has performed. If you have a SIPP or personal pension, you may have been asked to choose a fund yourself, in which case the default option is still typically available but you would have had to actively select it.

For a broader view of what to check and when, see How to Manage Your Pension.

What this means in practice

The summary is straightforward:

Growth stage means a higher tolerance for risk and a focus on long run returns. This translates to a portfolio that is heavily weighted towards company shares, diversified globally, and designed to compound over decades.

Income stage means a lower tolerance for risk and less need for high growth. This translates to a portfolio with more bonds and cash, designed to preserve what you have built and provide a more predictable income stream.

The shift between the two happens gradually, usually managed automatically by your pension provider through a lifestyle or glide path strategy. For most people in a workplace pension, this is happening in the background without them needing to do anything.

Understanding this does not mean you need to become an investment expert. But knowing what your money is doing and why it is doing it puts you in a much better position to assess whether your pension is working hard enough for you, and to ask the right questions if you think it is not.

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Key takeaway: Your pension investments change as you age. In the growth stage, your money is mostly in company shares to maximise long run returns. As you approach retirement, the mix shifts towards bonds and cash to protect what you have built. Most workplace pensions manage this automatically through a default fund.

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Frequently asked questions

What is my pension actually invested in?

Most workplace pensions invest your money in a default fund, which typically holds a diversified mix of company shares, government and corporate bonds, and sometimes property or infrastructure. The exact mix depends on your age and how far you are from retirement.

Do I need to choose my own pension investments?

No. Most workplace pensions put your money into a default fund that is managed for you, and for the majority of people this is a reasonable option. You can choose your own investments if you want to, particularly with a SIPP, but you do not have to.

Why does my pension hold stocks if they can go down?

Over the long run, company shares have historically produced higher returns than bonds or cash. Because pension saving typically spans decades, short term price falls are less of a concern than they would be for money you need next year. The higher return potential of stocks is what helps your pension grow over a working lifetime.

What is a lifestyle or glide path fund?

A lifestyle or glide path fund automatically shifts your pension investments from higher growth assets like shares towards lower risk assets like bonds and cash as you approach retirement. Most workplace pension default funds work this way. The shift usually begins 10 to 15 years before your target retirement date.