How Much Risk Am I Taking With My Pension?

What does investment risk actually mean?

When people hear:

risk

they usually think:

"Could I lose my money?"

That's certainly one form of risk.

But with pensions there are several.

You might face:

• Investment risk — investments fall in value.
• Inflation risk — your money doesn't grow enough to keep pace with rising prices.
• Concentration risk — too much money depends on one company, market, country or type of investment.
• Timing risk — investments fall just as you need to use the pension.
• Longevity risk — your retirement money needs to last longer than expected.

So pension risk is considerably broader than:

"Could the number on my app go down next week?"

Steve's observation

There is a strange assumption that the safest pension is the one that moves the least.

That might feel safest.

But if you have another 25 years before retirement and the money barely grows, you may simply have swapped one risk for another.

Less wobbling doesn't automatically mean less risk.

Why do some pension investments move more than others?

Different investments behave differently.

Company shares can rise and fall significantly.

Bonds generally behave differently from shares but can still lose value.

Cash tends to fluctuate less in nominal terms, but inflation can erode what it will buy.

Property and other assets bring their own risks.

That's why we first covered:

What Is My Pension Invested In?

If you don't know what's in the pension, it's extremely difficult to understand the risk.

What is volatility?

Volatility is basically a measure of how much an investment's value moves around.

Imagine two investments.

Investment A: £100,000 → £102,000 → £99,000 → £104,000 → £103,000

Investment B: £100,000 → £118,000 → £88,000 → £120,000 → £95,000

The second investment is considerably more volatile.

That doesn't automatically tell us what either investment will return over the long term.

But it tells us that somebody holding Investment B needs to be able to cope with much larger movements in value.

And that's where investment risk becomes emotional as well as mathematical.

How would you actually react to a fall?

It's easy to say:

"I'm comfortable taking investment risk."

when markets are rising.

The more useful question is:

"How would I feel if £200,000 became £160,000?"

Would you:

leave the strategy alone because you understand why you're invested that way?

or:

panic, sell everything and move to cash?

Because the second reaction can turn a temporary investment fall into a permanent financial decision.

Attitude to risk and capacity for loss are not the same thing

This distinction matters.

Attitude to risk

This is broadly about how comfortable you are with investment uncertainty and fluctuations.

You might describe yourself as:

• very cautious
• balanced
• adventurous
• or something similar.

But that alone isn't enough.

Capacity for loss

Capacity for loss asks a different question:

What would an investment loss actually do to your life and financial plans?

You could be emotionally relaxed about investment falls but financially unable to absorb a large loss.

Or you could be financially able to withstand substantial investment movements but hate every second of watching them happen.

Those are different issues.

Why does age matter?

Age by itself does not determine the correct level of investment risk.

What matters more is the time until you expect to need the money and what you intend to do with it.

Someone aged 35 may potentially have decades before accessing their pension.

If investments fall substantially, there may be considerable time for markets to recover — although recovery is never guaranteed.

Someone intending to use a large part of their pension next year has a very different problem.

A major fall immediately before the money is needed could have a much greater impact because there is less time available to recover.

This is why many pension default strategies reduce investment risk as the selected retirement date approaches.

But even that needs context.

What if I'm retiring but leaving the pension invested?

This is where the old idea of:

"You're retiring, therefore everything should become low risk"

becomes too simplistic.

Modern retirement can last decades.

If somebody plans to use pension drawdown, part of their pension might remain invested well beyond the day they stop working.

That means the investment timeframe doesn't necessarily end at retirement.

But the nature of the risk changes.

If you're taking withdrawals while investments are falling, you may have to sell more investments to produce the same income.

That can make it harder for the remaining pension to recover.

We've covered this separately in:

What Happens to My Retirement Income if Investments Fall?

and:

How Do I Make My Pension Last Throughout Retirement?

Can my pension be too cautious?

Potentially.

This is an important point because financial risk is often described only in terms of losing money.

Imagine somebody has:

30 years until retirement

and invests extremely cautiously because they hate seeing their pension move.

That may reduce short-term fluctuations.

But if the investments produce insufficient long-term growth, they could end up with less retirement money than they hoped for.

Inflation matters too.

If prices rise faster than the value of the pension over long periods, the purchasing power of that money falls.

So:

taking less investment risk can introduce other risks.

Steve's observation

If your retirement plan needs the pension to grow but you've invested it as though you need the money next Tuesday, that deserves a conversation.

Being cautious is not wrong.

But we need to understand what the caution costs us as well as what it protects us from.

Can my pension be too risky?

Yes, potentially.

Suppose you're planning to retire next year and need a large proportion of the pension immediately.

If that pension is exposed to investments capable of substantial short-term falls, you need to understand what would happen if markets fell immediately before you needed the money.

Likewise, holding a highly concentrated portfolio of individual shares, sectors or speculative investments could produce risks significantly different from a broadly diversified pension fund.

Again, there isn't one universal answer.

The question is:

What job does this money need to do, and when?

What difference does diversification make?

Diversification means spreading your investment exposure.

Instead of depending heavily on:

• one company
• one country
• one sector
• or: one type of investment,

a diversified portfolio spreads money across a range of investments.

This doesn't prevent losses.

During major market events, several different investments can fall at the same time.

But diversification reduces your dependence on one individual investment or part of the market behaving as you hope.

If you haven't already read:

What Is My Pension Invested In?

that's where we explain diversification in more detail.

My pension says I'm Risk Level 4. What does that mean?

Potentially very little until we know whose scale we're looking at.

A provider might use:

1–5

Another:

1–7

Another:

1–10

And the definitions may differ.

So:

Risk Level 4

doesn't have one universal meaning across every pension and investment company.

Find the provider's definition.

Ask:

• What investments does this fund hold?
• How much can they fluctuate?
• What is the stated risk category measuring?
• How does the provider describe the potential for loss?
• Is the scale relative to its own fund range?

Don't assume one company's:

4

is identical to another company's:

4.

Does a high-risk fund guarantee higher returns?

No.

This is critical.

Taking greater investment risk can provide the potential for greater returns.

It does not entitle you to them.

A high-risk investment can:

• perform brilliantly
• perform badly
• or: lose a substantial amount of money.

Risk is not something you pay in exchange for a guaranteed higher return.

What if my pension is in a default fund?

Don't assume the default means:

low risk.

A default fund can contain significant exposure to shares when retirement is a long way away.

Many then alter the investment mix as the selected retirement date approaches.

We've already explained this in:

What Is a Default Pension Fund?

The useful questions are:

• What is the fund currently invested in?
• What level of risk does it currently take?
• Does it change over time?
• and: What retirement date is it working towards?

That final question is surprisingly important.

What if the retirement date on my pension is wrong?

Suppose your pension thinks you're retiring at:

65

but you've decided to work until:

70.

If the investment strategy automatically reduces risk as age 65 approaches, it may begin doing so earlier than your actual plans require.

Or suppose the provider thinks you're retiring at 67 but you plan to stop at 60.

Now your pension may have less time than the strategy assumes.

That doesn't automatically mean the investments need changing.

It means:

your retirement date and investment strategy need to be considered together.

Should I change my pension to lower risk as I get older?

There is no universal rule saying:

"At age X, move your pension to Risk Level Y."

Your decision depends on things including:

• when you plan to access the pension;
• how you intend to access it;
• what other income and assets you have;
• how dependent you are on this particular pension;
• your investment objectives;
• your willingness to accept fluctuations;
• and your capacity to absorb losses.

Someone planning to buy guaranteed retirement income could have different considerations from somebody intending to leave a large pension invested for many years.

This is why personalised risk decisions require more than your date of birth.

What if I have several pensions?

Don't automatically assume they all need the same investment strategy.

One pension might be needed earlier.

Another might be left invested for much longer.

One might represent most of your retirement wealth.

Another might be relatively small.

And a defined benefit pension behaves very differently from an invested defined contribution pot.

Ultimately, risk should be considered across the wider retirement plan rather than looking at each pension in complete isolation.

The Four Questions to Ask About Pension Risk

Before deciding whether your pension feels:

too risky

or:

too cautious,

ask:

1. What am I invested in? Shares? Bonds? Cash? Property? A mixture?
2. When will I need the money? Next year? Ten years? Thirty years?
3. How would I react if the value fell substantially? Would I understand it? Or panic?
4. What would that fall actually do to my financial plan? Could my retirement still work? Would I need to reduce spending? Delay retirement? Use other assets?

That final question is particularly important.

What Should I Do Next?

Find your pension fund factsheet.

Identify:

• Risk rating
• Percentage in shares
• Percentage in bonds
• Percentage in cash
• Other investments
• Retirement date assumed

Then ask:

"If this pension fell significantly, how would I feel?"

and, separately:

"What would that actually do to my retirement plan?"

Those two answers begin to tell us considerably more about investment risk than simply looking at a number from 1 to 10.

Our next question is another important part of deciding whether the pension is actually good value:

How Much Am I Paying in Pension Charges?

Investment risk isn't something we should automatically try to eliminate.

It's something we need to understand and manage.

Take too much risk and a major fall at the wrong time could seriously damage your plans.

Take too little and your pension may struggle to grow enough to achieve what you need.

Neither extreme deserves a medal.

Steve's observation

A pension shouldn't be so risky that you can't sleep at night.

But it shouldn't necessarily be so cautious that your retirement plan falls asleep as well.

Risk has a job.

The important thing is making sure it's doing the right one.

Worried your pension is too risky — or wondering whether it's actually too cautious? Start by understanding what's inside it, how much it can fluctuate, when you'll need the money and what a significant fall would actually mean for your retirement. If you'd like help understanding the risk you're taking and how your pension fits into your wider retirement plans, speak to Open Door Wealth.