How Workplace Pension Investments Work

How pension investments work

When contributions are paid into your pension pot, they are invested in funds. A fund is a pooled investment vehicle. Your money is combined with that of other pension savers and invested collectively in a range of assets. This pooling allows access to a diversified portfolio that would be difficult to replicate with a small amount of money invested individually.

The value of your pension pot changes over time as the value of the underlying investments rises and falls. Over the long term, a well-diversified investment portfolio has historically grown in value, but there will be periods of short-term falls, particularly during economic downturns or market corrections.

Types of investment assets

Pension funds typically invest in a mix of asset classes, each with different risk and return characteristics:

Equities (shares in companies) offer the highest potential returns over the long term but with greater short-term volatility. A pension invested heavily in equities may fall significantly in value during a market downturn, but historically has recovered and grown over time.

Bonds (loans to governments or companies) are generally lower risk than equities and provide more stable returns, but with lower long-term growth potential. Government bonds (gilts) are considered lower risk than corporate bonds.

Property funds invest in commercial real estate. They offer diversification and can provide steady income, but can be illiquid, meaning it can be difficult to sell the underlying assets quickly.

Cash and money market funds offer stability and capital protection but very low returns, particularly in a low-interest-rate environment. They are generally used as a short-term holding or to reduce risk close to retirement.

Risk and return

In investing, risk and return are generally related, higher potential returns come with higher risk of short-term losses. For pension saving, the appropriate level of risk depends on your time horizon (how long until you need the money), your capacity for loss and your personal attitude to risk.

For younger savers with decades until retirement, a higher allocation to equities is generally appropriate, there is time to recover from short-term falls and benefit from long-term growth. As you approach retirement, reducing risk by shifting towards bonds and cash helps protect the value of your pot.

Steve's observation

One of the most common mistakes I see is people becoming nervous during market falls and moving their pension into cash. This locks in the loss and means they miss the recovery. Pension investing is a long-term activity, short-term volatility is normal and expected.

If you are 20 or 30 years from retirement, a market fall of 20% or 30% is not a disaster, it is an opportunity. The contributions you make during a downturn buy more units at a lower price, which means you benefit more when the market recovers. The key is to stay invested and not panic.

The default fund

Most workplace pension schemes place new members into a default investment fund unless they make an active choice. The default fund is designed to be broadly appropriate for most members, typically a diversified multi-asset fund with a growth-oriented strategy for younger savers.

The default fund is not necessarily the best choice for everyone. If your circumstances, risk tolerance or retirement plans differ significantly from the average member, it may be worth reviewing whether the default fund is right for you. Guide 9 explains default funds in more detail.

Lifestyling

Many default funds use a strategy called lifestyling, which automatically adjusts your investment mix as you approach your target retirement date. In the early years, your pension is invested predominantly in growth assets such as equities. As you get closer to retirement, the fund gradually shifts towards lower-risk assets such as bonds and cash.

Lifestyling is designed to protect the value of your pot as you approach the point when you need to access it. However, the strategy is typically designed around a specific retirement outcome, for example, buying an annuity. If you plan to take your pension differently (for example, through drawdown), the default lifestyling strategy may not be appropriate.

Making your own investment choices

Most workplace pension schemes offer a range of investment options beyond the default fund. You can usually choose from funds with different risk profiles, asset classes and investment strategies, from cautious multi-asset funds to specialist equity funds focused on specific sectors or geographies.

Making your own investment choices gives you more control but also more responsibility. If you are not confident in making investment decisions, staying in the default fund or taking financial advice is a sensible approach.

What to do next

Find out which fund your pension is invested in and check whether it is appropriate for your circumstances. If you are unsure, Guide 9 explains default funds in more detail, and Guide 11 covers how to review your investments.