Younger savers are traditionally told to take greater investment risk as they build up a pension, and only ease off as they approach retirement or in old age.
State-funded pension provider NEST has junked this conventional thinking, and puts its fledgling pension savers in lower risk investments unless they actively opt for more adventurous funds.
NEST, set up as a low-cost scheme for employers needing to auto-enrol staff into pensions, hopes to deter young people from losing faith if they lose money in volatile markets.
Safety first: Should young pension savers be guarded from market shocks?
It also argues that investing cautiously in the very early years makes little to no difference to the eventual size of retirement pots.
We explain NEST’s uncommon approach to pension investing below, while a financial expert defends the conventional strategy of encouraging younger savers to ride out market storms for the sake of long term gains.
How does NEST invest young savers’ pension money?
NEST runs nearly 50 ‘retirement date’ funds on behalf of savers, which are each targeted towards the year someone is due to retire. The youngest workers are currently placed in the 2063 fund, for example.
Those aged 22-27 are put in ‘foundation phase’ funds covering the first five years of saving for a pension.
However, these contain less risky investments than the ‘growth phase’ funds covering the subsequent 30 years.
The final ‘consolidation phase’ ramps down the risk again in the final 10 years before retirement, while taking account of more people now staying invested in old age.
The lower risk funds are invested in shares, property, corporate bonds and government debt, with the intention of reducing volatility so young people new to pensions don’t lose a big chunk of their early contributions. See the asset allocation of the 2060 fund below.
Portfolio breakdown: How the fund for people retiring in 2060 is invested (Source: NEST)
NEST’s update on investment performance to the end of March 2017 shows that returns are smaller for savers in these lower risk funds.
For example, the 2060 fund has made 9 per per cent since launch and 16 per cent over the past year. Meanwhile, the 2040 fund for older savers which takes more risk has made 10.8 per cent since launch and 22 per cent over the past year. See the full results for all NEST funds below.
Does it matter if young savers invest cautiously at the outset?
NEST says its approach of investing at lower risk in the first five years makes no or little difference to the eventual size of a pot, after carrying out research based on 10,000 modelled scenarios over a 45 year saving horizon.
Paul Todd, director of investment development and delivery, argues that ensuring younger people keep paying in is crucial in the very early stages, because contributions are bigger and more significant to a pot at that point, while maximising returns is more significant in the later stages of saving for retirement.
So for example, a saver maintaining contributions at £100 every year at the very start is more important than whether their return is £11 rather £9 in a single year in that early period.
Paul Todd: People on low incomes feel uncomfortable and nervous about investing
People using NEST are often on modest wages and began saving into a pension under auto-enrolment, which began forcing all employers to set up workplace schemes from 2012 onwards.
Todd explains that most don’t have experience of investment, and research into their attitudes shows they are very risk averse.
‘People on low incomes are incredibly financially sophisticated in terms of day to day or month to month budgeting, but when we have done research about how people should invest most of this is quite alien. People feel quite uncomfortable and nervous.’
Todd says opt-out rates by people auto-enrolled into pensions have been low so far, but investment returns have been impressive over the past five years so no one yet knows what will happen in a period of high volatility.
However, he points to research carried out before and after the financial crisis in 2007-2009 into the behaviour of 25,000 people investing via a work pension, who had similar characteristics to those with no pension.
All stayed employed and in their pension schemes, but 15 per cent stopped paying in, 6 per cent cut contributions, 25 per cent switched funds and/or contribution patterns, and 54 per cent took no action. The research is summarised in a NEST report here.
Todd believes the real test of whether young savers in lower risk NEST funds are more likely to stick with pensions or ditch them will be the next time market volatility gets as intense as in the credit crunch.
Jason Hollands: ‘The most valuable pounds you’ll ever put in your pensions will be the first ones, as these have longer to grow in value’
Meanwhile, young NEST savers who want to take more investing risk can opt out of their default ‘retirement date’ fund and put their money in a higher risk one.
Aside from its default funds, NEST offers ethical, sharia, lower growth and higher risk options.
In practice, around 90 per cent of NEST savers stick with their default fund, which is in line with the stay-put rate of other pension providers.
What’s the argument for taking more investing risk when young?
For young people a pension is a really long-term investment, says Jason Hollands, managing director of financial planning firm Tilney
The returns at the end are ultimately down to how much you put in, the returns on the investments you choose and the amount of time you stay invested, he says.
‘As young pension investors have decades until they can access their investment, they can and should take a riskier approach initially by focusing on equities which historically have consistently beaten other types of investments for long-term returns,’ says Hollands.
‘Stock markets can however be volatile over shorter time periods and will from time to time go through periods of losses. These are however generally short-lived events and therefore long-term investors should not shy away from investing in equities.
‘They will have plenty of time to see their investment more than recover from any brief down periods, which actually provide good opportunities for making new investments.’
The latter scenario is because stocks can be ‘cheap’ to buy during market troughs, if you have a long enough time horizon to wait out market upsets.
Hollands says he can see where NEST is coming from, with its approach of initially putting younger investors into lower risk investments, and that it is driven by concerns that those who lack knowledge or confidence might give up pension investing if they see losses during their first few years.
‘It is a carefully weighed up assessment that it is better to have young investors continue to save something, rather than risk scaring them off altogether,’ he says.
WILL THERE BE A BOND CRASH?
Safety-first investors have poured cash into government and corporate bonds in recent years – they provide a higher income than savings at a time of rock bottom interest rates, and are perceived as less volatile than shares.
But the market is skewed by years of heavy purchases by central banks using newly-printed money, and investing experts have predicted a market upset for years – although it hasn’t materialised yet.
Read more here about investing in government bonds.
‘But from a pure investment perspective, this is not the right approach and the real issue here should be to better educate young investors or potentially prevent younger auto-enrolled savers from opting out during their first three to five years so that they don’t have the option of panicking out of pension saving altogether.’
Hollands adds that ‘lower risk’ might also not work in practice if this means putting more of a portfolio in government bonds, because they are very expensive right now after years of central banks buying them to prop up prices and keep yields artificially low. See the box on the right.
‘As expectations of interest rate rises build – as they have been in recent weeks – this will see prices fall and investors sustain real, capital losses.
‘Dull returns and potential losses on bond holdings may not prove a recipe for persuading young pension investors to keep investing,’ he says.
The NEST 2060 fund portfolio featured above includes some exposure to UK government debt, and also to emerging market debt.
Hollands concludes: ‘The most valuable pounds you’ll ever put in your pensions will be the first ones, as these have longer to grow in value. The longer you delay pension investing, the more you will ultimately have to put in to catch up on lost ground.’
WHAT IS NEST? A STATE-FUNDED PENSION PROVIDER SET UP ALONGSIDE AUTO-ENROLMENT
NEST, or the National Employment Savings Trust, was set up in late 2012 alongside the Government’s auto-enrolment initiative which forces all employers to set up workplace pension schemes.
This was because a state-funded provider was needed for employers which either couldn’t or didn’t want to contract out their pension business to a big insurer or set up a trustee-run scheme of their own.
NEST is free for employers, and offers a simple charging structure and online tools and services to members.
The annual management charge is 0.3 per cent of the total value of a member’s fund each year. There is also a contribution charge of 1.8 per cent on money going into a member’s retirement pot
If a member’s pot was worth £10,000, they would pay an AMC of £30. If £1,000 was paid in over a year, the contribution charge would be £18. That would bring the total charge to £48, or just under 0.5 per cent of the total value of their retirement pot.
In addition to its ‘retirement date’ funds, NEST offers ethical, sharia, lower growth and higher risk funds.
The total minimum auto-enrolment payment is currently 2 per cent of salary – split between contributions from individuals and employers and tax relief from the Government – although it’s set to rise in stages to a total of 8 per cent in April 2019.
All workers aged between 22 and state pension age and earning more than £10,000 a year automatically start contributing towards a pension, unless they make an active move to opt out. The programme is currently being extended to micro-firms with one member of staff.
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