On pensions, part 4: building a strategy

So you’ve got your Stakeholder Plan and a simple online management tool. How do you use them? Here’s how I do it: a simple investment strategy that takes barely an hour a month to administer.

It relies on three principles: a) the market knows more than you; b) retail pension funds have two good years; and c) charges are your enemy.

First , work out what you want, so you can spend the next couple of decades getting it. A £350 monthly contribution, rising by 10% each year will, over 25 years, grow to a £1.6m pot if you keep an 8% return over costs and inflation. It can be done – but you’ve got to be active about it. Here’s what I do.

Choosing your funds

Risk-taking and yo-yo’ing may produce great returns by chance over a short term, but we’re looking for long-term growth here. Hence my rule: don’t bother with company shares. As a retail investor, you’re there for one thing: to absorb risk on behalf of institutional investors (i.e making sure they make money, not you). No retail investor ever makes money consistently over time.

The vehicles to invest in are pension funds, a spread of investments packaged together (usually on a theme, such as mining companies or technology businesses.)

If you’ve opened a Stakeholder or SIPP, your provider will have a wide range of funds to invest in. They’re sold in “units” (you can buy fractions of a unit, so you never have money sitting there uninvested) and the better fund providers let you choose and swap your investments online. It’s a liquid and transparent market, with unit prices published in places like the FT.

The list of funds offered may run to over 100 entries, so let’s narrow it down using two parameters. First, only go for funds marked “Acc” – accumulators, where any returned income (such as dividends) is automatically re-invested in your fund. (This is a pension; you’re looking to build it up, not withdraw from it.)

Second, only go for funds offered by your pension provider, not “external” funds it offers on behalf of other providers – these will carry “external fund charges”, and it only takes a couple of those to seriously eat into your growth. (One thing pension fund providers aren’t good at, for obvious reasons, is making clear how much they’re skimming off your fund each year.)

I choose my funds on a simple algorithm: whatever’s been doing well over the last year, I invest in. My feeling is that a pension fund has a couple of good years in any investment cycle. I try to catch that fund as it’s warming up, with a few quarters of solid growth behind it and a few more ahead. It means I’m never buying the cheapest, but usually the most solid. The returns you can make here can run above 12% consistently, if you pay attention.

Deciding how much to invest

Remember that £1.6m pension pot that’ll provide an upper-percentile income from age 60+? To get it, you need to invest about £350 a month gross, and get an 8% return over inflation and fees, every year. Realistically that means a gross return around 13%. Keep about half a dozen funds in your pot, and the fees will be around 1.5% a year (the maximum they’re allowed to charge – some providers charge less. Just remember there’s a fee per-fund which may drive your total fees higher. Sometimes it’s pleasantly cheap, though: one UK fund charges an annual management fee of just 0.15%.)

There’s another thing you need to do: tie your contributions to your earnings as they rise over the years. That £1.6m pot needs that £350 to rise by 10% every year. About 3% a year will, over time, only keep pace with inflation. About 6% a year will make your contributions double in a decade… and wages rise at about that rate, so you’re keeping pace while being able to afford it.

The younger you are, the more flexible you can be here. If you’re under 30, that £1.6m pot costs less than half as much each month to build. The moral? Start young.

Keeping it up!

In the private pensions market, a huge percentage of people simply stop making contributions after the first year or two. It’s too hard, too expensive, and they lose faith in something they won’t see the benefits of for decades. (It’s easy to understand why. Many Stakeholder pension providers choose rather low-risk, and therefore low-return, funds for you. That’s why I want to have a say in the choice myself.)

So the last part is keeping your pension top-of-mind.

First, set aside one Saturday morning each month to review your portfolio and make any changes. It only takes two hours and can be fun. Simple rules – like mine, which sums up as always keeping the top 4-6 funds, whatever they are, in the portfolio – work. I tend to keep 10% or so in something solid and stolid, like UK Gilts (which only return a few percent) but over 80% of my portfolio is in moderate-risk funds like smaller companies. That suits my risk profile; yours will be different.

Second, watch the numbers over time. You’re not a momentum trader; you’re looking at long-term performance, not short-term dips. 2011 has, of course, been pretty awful. Look at the graph over the last year; you’re looking for smooth and steady above-inflation returns with a reasonable chance of continuing. There are plenty of websites that’ll track your investments for you. Use them. (Morningstar is among the most complete.)

Third, know what they’re charging and what inflation is today. Add these numbers together and you’ve got a figure – possibly as high as 7% – and that’s the amount your pension provider and the invisible hand of economics are taking out for themselves. And they take it out every year, whether your investments have grown or not.

This is the biggest pitfall in the pensions biz, and it hugely affects your longterm projections.

On my plan, a two-percentage-point difference in overall return is the difference between my pension pot lasting a couple of years and lasting… forever. By “forever” I mean that taking out my planned income, an amount that rises with inflation each year, only reduces the pot by a proportion of its growth over inflation – in other words, I’m living off the interest after inflation, keeping the capital’s buying power constant.

(Think it’s stupid to have a pension pot that lasts “forever”? In today’s world, the fastest-growing demographic is people over 100. You could be living off that pension income a long time. So you need to make sure it’ll last.)

And that’s how I do it. Make your own decisions – but remember, it’s all up to you.

One thought on “On pensions, part 4: building a strategy

  1. Pingback: On pensions, part 3: setting things up « Chris does Content

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