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Are There Any Risks Involved With A Money Purchase Pension?

Is there any truth to the claim that at the end of every rainbow is a leprechaun guarding a pot of gold? Obviously not. Likewise, there is no truth to the claim that a money purchase pension, also known as a defined contribution pension, guarantees a retirement income greater than the amount of money invested. In simple terms, there is no risk-free investment on the planet. The benefit of the money purchase scheme is that its risks are relatively low when compared to other kinds of investments.

The low risk of the money purchase pension is one of the things that makes it attractive as a retirement vehicle. But that low risk also translates into relatively low reward. Pension savers have to balance their appetite for risk and reward against their goals for retirement. Some choose to invest only in pensions while others combine pension saving with other kinds of investments. What you do is entirely up to you. The only thing we would caution is that you avoid doing nothing. Relying solely on the state pension as your only source of retirement income is not wise.

Money Purchase Investment Risks

A money purchase pension relies on external investments to generate a return for members. In a legal sense, this sort of pension is established through a contract between pension operator and either an employer or an individual participant. Contracts involve employers where workplace pensions are concerned; they are between individual members and operators when you are talking stakeholder pensions and SIPPs.

Once a pension contract is established, the scheme begins receiving contributions from members. The pension operator must make money in order to stay in business, so they take the money contributed by members and they invest it. Whatever they earn from those investments is distributed amongst themselves and their members. Here is where the investment risk of the money purchase pension comes into play.

Pension operators have a fiduciary responsibility to their members and their own investors to engage in sound investment strategies. The idea is to generate as high a return as possible while also mitigating losses. Pension operators usually invest in the following:

  • Individual stock market opportunities
  • Mutual funds and similar products
  • Property funds
  • Equity and growth opportunities
  • Corporate and government bonds.

As long as a pension operator's investments perform well, pension scheme members earn money. That is to say, they will eventually receive more in pension payments than they put into their pots by way of their contributions, employer contributions, and government tax relief. But the opposite is also true. Poorly performing investments could mean that an individual member actually loses money over time.

Choosing Your Investment Options

The money purchase pension is, by its nature, designed to be a low-risk investment tool for average investors. A result of this low-risk design is that pension savers are limited in the number of investment options they have available to them. For example, your workplace pension may only give you a choice of three or four mutual funds and perhaps an individual stock or two. You then direct how much of your contributions you want to go into each opportunity.

This is something that you should take seriously. Engaging with your pension provider opens the door to taking advantage of every opportunity they offer. If you simply allow your employer to deduct money from your pay without paying attention to how your pension operator is investing it, you have no way of knowing whether or not your pension is performing up to your expectations.

Experts recommend routine engagement with your pension provider. If your company is large enough to have a dedicated human resources department, there is likely a person within that department who has been designated with the task of being the contact person for pensions. That person would be the place to start the engagement process. If your company does not have a designated representative, contact your pension operator directly.

Here's what you need to know:

  • Investment Opportunities – You need to know what investment opportunities your pension provider makes available. You also need to know how each of those opportunities performs historically. How much do they typically earn in a given year? Do they earn consistently? Are there other opportunities that might be better suited to your needs?
  • Additional Opportunities – From time to time, a pension scheme will offer an additional opportunity that may not have been offered in previous years. Such an opportunity may be your key to much better earnings during the life of your pension. However, you will not know about such opportunities if you are not engaged with your pension provider.
  • Fees and Charges – It costs money to maintain your pension pot year after year. Where does the money come from? Your pension operator deducts it from your account. For every pound that comes out of your account, you have less available to earn a profit. Therefore, you need to know what the annual fees and charges are. If they are prohibitively high, you might be spending too much just to maintain what you have. Transferring out of your workplace pension and into a personal pension may be a better strategy.

Eventual Retirement Risks

All of the risks associated with a money purchase pension are not on the front end. In other words, the investment risks you take during your pension saving years are only part of the equation. There are other risks to consider once you start accessing your funds in retirement. First among them is running out of money.

There are many different options for how you use your pension funds in retirement. In years past, the default option was to convert your pension pot into an annuity through your current pension provider or another institution. Annuities are attractive because their associated risks are low. You get a guaranteed income for life regardless of how long you live.

What if you choose not to purchase an annuity? You could:

  • use your pension pot has a bank account
  • cash out your pension pot entirely
  • enter a drawdown contract
  • transfer your pension to a QROPS or SIPP
  • leave your pension alone and let it continue earning.

All of these options come with advantages and disadvantages. If you are not careful, however, you could run out of money before you die. That's the biggest back end risk of a money purchase pension. It is a risk final salary pension members don't have to consider – they are guaranteed retirement income.

Another risk is not leaving enough for your beneficiaries when you do eventually pass on. If you're planning to use your pension as a means of leaving a considerable amount of money to your spouse and/or children, you need to make sure that your current pension saving strategy is designed to achieve that goal.

One final risk on the back end of pension saving is that of taxation. Depending on how much money you put away in total, you could be subject to significant taxes once you start withdrawing the money. There are also taxes upon your death to be concerned about. Such taxes have been reduced in recent years, but they still are a reality to be reckoned with.

As you can see, the money purchase pension is not risk-free. Risks are low, but they still exist. We hope you will take the time to learn about the risks and understand how they apply to your situation. Knowing your risk level is important in determining how you will plan for your retirement.

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