How to make the right choices in accumulation

The process by which individuals build their pension pots is called accumulation.

While several choices exist depending on people’s different desired lifestyles, how do individuals make sure they make the right accumulation choices for the long-term?

This matters as, according to Sir Steve Webb, director of policy at Royal London, individuals who were members of a defined benefit pension scheme did not have to give much thought to the rate at which they built up their pension wealth.

While passive has performed well in the past few years, there are times when it is worthwhile paying for an active manager.Nathan Harris

He says: “Their own mandatory contributions, plus a substantial contribution from their employer, meant that as long as they had reasonably long service they would be comfortably off in retirement.”

He adds: “But in a world where millions of workers never had access to a DB pension, growing attention will need to be focused on helping people build up the right sort of defined contribution pot.” 

Risk and return

Royal London research suggests that, in addition to a full state pension, someone on average earnings needs to target a pension pot of around £290,000 for a comfortable retirement. 

Several experts highlight that retirement savings are mainly influenced by risk and return levels.

Nathan Harris, a chartered financial planner at Lothbury Group, says: “The higher the risk, the higher potential return, but equally it requires an individual to be prepared to accept volatility in their funds' value.”

Mr Harris suggests that cost will also impact how quickly the funds grow, which means passive investing may be the best approach.

But he adds: “While passive has performed well in the past few years, there are times when it is worthwhile paying for an active manager.”

Mihir Kapadia, chief executive of Sun Global Investments, also links pensions accumulation to risk and return.

“Risk and return are at the forefront of any individual’s mind when it comes to making the right choices in accumulation. To do this, it is important that consumers try to maximise return for a given level of risk, which is consistent with their risk tolerance,” he says.

Accumulation options

Mr Kapadia believes individuals should consider if they need income immediately or whether they have the flexibility to grow it over the long-term.

“If you require a regular income from your investments then an income fund could be beneficial as they combine the short-term benefits of a regular income with those of a much longer term investment,” he explains.

Mr Kapadia adds: “Alternatively, the individual can choose to reinvest funds instead, which will allow them to grow faster alongside the potential for profit. If not, then more money can be invested and will be subject to the risks in the stock market.”

Steve Pennington, head of wealth planning at Arbuthnot Latham, points out using tax-advantaged vehicles greatly helps in the accumulation process.

“Making regular contributions into Isas and pensions allows for pound cost averaging, as the funds are invested in the market at different times,” he explains.

While Sir Steve says: “There is no single, right amount to save, but starting earlier and increasing gradually as wages rise is the best approach.

"In addition, maxing out on any employer contribution is likely to be the least painful way to build up a substantial pot.”

He explains a “rule of thumb” for building pre-retirement income:

• A total income of around two-thirds of your pre-retirement income should allow you to glide into retirement with little noticeable change in living standards.
• For someone on average earnings, the state pension will provide roughly one-third in retirement, so private savings need to contribute the other third.

He adds: “Current automatic-enrolment rates will probably only generate an income of around one-sixth of the average wage, and less than this for those who started pension saving later in life.”

Ricky Chan, chartered financial planner and director at IFS Wealth, says given that self-employed people need to pick their own funds when choosing a pension, using a simple, low-cost multi-asset global tracker fund or insurance company’s lifestyling fund should suffice.

He adds: “When values become more significant, then this should warrant using additional funds and/or a more bespoke portfolio of funds.”

Weighing the choices

Commentators stress that making the wrong accumulation choices can have a substantial long-term impact.

Mr Chan says: “[This is] Potentially very significant given the typical investment time horizons of over 40 years, so a small mistake at the start of the journey could be compounded to become a disastrous error if it’s not corrected early.”

Mr Pennington suggests there should also be a discussion about protecting the downside.

“What if things do not go to plan, or perhaps the breadwinner becomes ill or prematurely dies?” he questions.

Mr Pennington adds: “Using a protection plan (an insurance policy) can provide the needed funds when an unexpected/unforeseen event occurs and, as a result, the accumulation plan can still be achieved.”

saloni.sardana@ft.com