Scottish Widows - Understanding how pensions are invested
Pension Awareness Day is the ideal opportunity to get to know your pension, and how it is usually invested. Besides your home, your pension is probably the biggest investment you’ll make in your lifetime. Saving into a pension gives your money the opportunity to grow to meet future goals.
The money you pay in - known as contributions - receives tax relief from the Government, subject to your individual circumstances, which helps increase the value of your savings. If you’re employed, you’re likely to be saving into your workplace pension where your employer makes contributions as well as you. Some people, typically the self-employed, will have a personal pension.
Whichever type you have, you’ll need to decide where to invest your contributions. That’s because saving into a pension is not the same as saving into a bank account, where your money sits to earn interest. With a pension, your money goes into investments. You have to accept some level of risk when you make an investment but how much depends on what you want to achieve and how quickly you hope your money will grow.
Investments come in all shapes and sizes but the most common for pensions are bonds, property and shares in companies, also known as equities. Bonds are essentially loans sold by a company and bought by an investor who is usually paid interest for as long as they hold the bond. Bonds can also be issued by governments: UK Government bonds are called ‘gilts’, for example. Most bonds provide a regular, stable income from their interest payments.
Equities typically make up the biggest proportion of investments in a pension while you’re building up your savings, which means you’ll be investing in the stock market.
What is the stock market?
The stock market may conjure up images of traders screaming ‘buy’ and ‘sell’ as if they were in Hollywood blockbuster The Wolf of Wall Street, but nowadays exchanges exist as electronic marketplaces. The concept of the stock market is fairly simple. It’s like any other market but instead of goods, you’re buying ‘stocks’. Stocks are typically shares in a company. So if you buy shares in Google, for example, you own a small part of that business and get to share in the company's success - or if you’re unlucky - its failure. If the price of the stock goes up, you make a profit when you sell it and your pension value would rise. If the price goes down, you make a loss, and your pension value could fall.
How are shares priced?
Share prices are governed by supply and demand. At any given time, there's a maximum price someone is willing to pay for a certain company’s shares and a minimum price someone else is willing to sell them for. Think of stock market trading like an auction, with some investors bidding for company shares that other investors are willing to sell. If there is a lot of demand, investors will buy shares quicker than sellers want to get rid of them, and the price will move higher. On the other hand, if more investors are selling a company’s shares than buying, the market price will drop.
Demand for a company’s shares will depend on how well that business is doing, or expected to do. This can also be influenced by the general health of the economy. Other factors sometimes come into play too, such as certain industries performing well or badly following a major event or news story, for example.
Most pensions invest in the stock market through funds which bundle together the shares of various companies.
What are funds?
Funds pool together the money of lots of different investors and a fund manager invests on their behalf.
There are two main types of fund. With actively managed funds, the fund manager decides when to buy and sell investments with the aim of delivering a return that's better than the stock market.
Passive funds track a stock market index, aiming for steady performance rather than maxing returns. An index measures the performance of a group of stocks that fall within a certain category or share certain characteristics. The FTSE 100, for example, is considered the UK’s leading index and measures the performance of the biggest companies on the London Stock Exchange.
Funds can be made up of in a single type of investment, such as equities or bonds. Or a mix of different types of investments, known as ‘multi-asset’ funds.
Increasingly, pension funds are being invested more sustainably. Sustainable – or responsible - investing aims to create a positive impact on the environment and society while growing pension savers’ money.
As well as taking financial factors into consideration when assessing if a company represents an attractive investment, sustainable investing assesses how companies behave in relation to the planet, people and the way they’re managed. It prioritises investment in companies that are working hard on things like reducing their impact on the environment and improving people’s wellbeing. By investing in this way, it doesn’t have to mean you’re sacrificing growth. Research shows that companies that are run in a sustainable way also tend to do well. They’re typically better positioned to adapt to long-term challenges, such as climate change. And they’re less likely to suffer falls in their value from scandals or fines.
Making your choices
Unless you’re a member of a defined benefit pension, where investments are usually chosen by an employer, you’ll typically have a range of funds with different risk levels and investment approaches to choose from.
You can change where your pension is invested, and many people opt to reduce their amount of risk as they get nearer to retirement. Many workplace pensions do this automatically for you through something called ‘lifestyling’. This is often the default option if you don’t make your own choice. Lifestyling invests more of your pot in riskier investments which tend to provide the best growth, such as equities, when you’re younger and as you near retirement your savings are gradually shifted towards less risky investments such as bonds and cash.
Find out more
At Scottish Widows we have lots of information to help you understand how your pension is invested. A great place to start is our Investment Essentials website which can help you whether you want to understand the investment basics or keep up with the latest investment trends. Our experts are on hand to help with investment blogs, films and more on our investment approach.