How to build your first pension or expand an existing one

Creating a plan for your retirement savings now could put you in a better position later in life. You will thank yourself for getting your finances in order – it should not take long and could bring peace of mind knowing that you have a pension strategy in place.

The first step is to find out if you have existing pension assets. Certain people might already have the core foundations in place, even if they do not realise it.

An employer will automatically enrol staff aged twenty-two in full or part-time employment or older into a workplace pension, unless they choose to opt out of the scheme. That means they are making contributions to a pension every month, topped up by money from their employer and the government.

Those with a workplace pension may find it does not fulfil all their needs as there can be a limited choice of investments. Setting up an additional pension you run yourself – known as a SIPP or self-invested personal pension – alongside a workplace scheme is one way to access a greater range of investments.

Individuals confident enough to run their own pension might even transfer one or more workplace schemes into a SIPP, so they can have greater control over the investment choices. Certain employers are happy to make monthly pension contributions into a SIPP, but others might restrict their payments to a workplace scheme so check first before making the switch.

Self-employed workers do not have the luxury of auto-enrolment so they must make their own pension arrangements.

Those who decide to open a SIPP need to establish if this is going to be their main pension or complementary to an existing workplace retirement savings scheme. It matters when you come to working out the balance of your pension assets – such as what percentage you might want to hold in shares, bonds or other asset classes.

Asset allocation plan

Whether you are running your pension yourself, putting money into a SIPP alongside a workplace pension, or having everything in a work pot, it is important to think about asset allocation as well as the individual investments that go in a portfolio.

Individuals with a workplace pension might find they invest in something called a ‘balanced managed fund’. Each £100 invested in this fund is allocated to a range of investments such as 20% in UK shares, 50% in overseas shares, 20% to 25% in bonds and up to 5% in cash. The weightings can vary from fund to fund.

This type of asset split is a good starting point when building a plan, but asset allocation comes down to your personal preference and the level of risk you are willing to accept, as well as your personal financial circumstances.

One way is to divide assets into either growth or stability. Younger people might prioritise shares over bonds because historically they have delivered superior returns over the long term. Those still in employment might want to consider reinvesting any dividends or interest payments from bonds or choosing a fund that does this automatically for you.

By reinvesting, you are effectively growing your capital in a smarter way, because the money buys more shares or units in addition to your original capital, which in turn attracts more interest or dividends.

Those nearing retirement, or already in it, might have a higher weighting to bonds because they might bring more stability to a portfolio with the main emphasis on generating income rather than capital gains.

Choosing the investments

Once you have worked out an asset allocation plan, it is time to select the individual investments. In the world of investing, the future is unknown, leaving investors to make their collective best guesses as to what is most likely to happen. It is not unlike the weather with certain days providing glorious sunshine and others a torrential downpour. In other words, it pays to take pack an umbrella as well as shorts and a hat.

Consider choosing investments with different return expectations and different risks. Ideally, you want to smooth out returns with certain investments going up as other fall, rather than having all your eggs in the same basket.

One common mistake is to act like a collector, buying investments without regard to the way that each fit into the portfolio. Each investment should bring something different, and the aim is to achieve the highest returns with the lowest risk.

It is possible to buy individual company shares or get exposure to them through investment funds. Certain people like researching companies and picking the ones they think will do best. Others either do not have the time or the knowledge and just want broad exposure – they either buy a fund run by a fund manager or a tracker fund that mirrors a specific part of the market.

You can choose from a wide range of funds – for example, ones that focus on a certain geography such as the US or Japan, or an industry sector like technology. There are funds that invest in companies which pay generous dividends, and you can even find funds to play certain themes such as artificial intelligence.

Investors often use a workplace pension to get broad exposure to stocks and shares around the world and a range of bonds – these might form the ‘core’ part of their retirement savings. They might also have a SIPP to invest in specialist areas of the market which might not be available via workplace schemes – these represent the ‘satellite’ part of their strategy.

Other investors might decide to consolidate all the pensions they have built up during the working lives into a single SIPP and take full control of their retirement savings strategy.

Whichever route you decide to take, it is worth following these four golden rules:

1. Pay in as much as you can afford

Certain people underestimate how much they need in retirement to fund a decent lifestyle so the more you save now, the better.

The latest PLSA ‘Retirement Living Standards’ report says an individual would spend £31,300 a year to maintain a ‘moderate’ life in retirement, factoring in costs for home, food, transport, holidays, leisure, clothing and footwear, and gifts for family and charities.

AJ Bell has calculated the size of a pension pot needed to achieve various levels of annual expenditure. Assuming 4% annual investment returns after charges, income rising by 2% per year and the fund lasting for 25 years in retirement, the table shows how the pot size for different scenarios.

It is worth noting these calculations account for contributions from a full state pension. For example, the table shows ‘zero’ for the pension pot needed to fund a minimum standard of living for a couple because the full state pension covers the entire £22,400 amount.

Estimated retirement fund needed to deliver Retirement Living Standards in drawdown

Minimum living standard: £14,400 (individual), £22,400 (couple) / Moderate living standard: £31,300 (individual), £43,100 (couple) / Comfortable living standard: £43,100 (individual), £59,000 (couple)

2. Be diversified

It is important to spread the risks across your portfolio. If you want to take control of your pension and consolidate all your workplace schemes into a single SIPP, there are dangers to consider if you put everything in the same place.

For example, someone might take the view that the technology sector is the best place to find growth opportunities. Only having tech-related investments might work out for a period but think about what happens if tech goes out of favour or there are headwinds to the sector such as regulatory interference. A lack of diversification means not having anything else to fall back on during tougher times.

You should also check with existing schemes that there are no guarantees or valuable pension scheme features that would be lost on transfer.

3. Give your pension an annual check-up

We discussed the importance of having an asset allocation plan earlier in this article. Once a year it is worth revisiting that plan and seeing if your pension pot or pots has deviated from it.

You might find certain assets are doing well and others are not – that can cause you to be overweight versus your plan in certain areas and underweight elsewhere. Trimming areas that have done well and redeploying the proceeds into the laggards is one way to rebalance your portfolio and align it with your original asset allocation plan.

4. Be patient and do not over-trade

People buy or sell something in their portfolio for reasons including: a stock or fund is falling in value, and they panic sell; they find a new idea and buy it; they are bored and constantly fiddle with portfolio positions.

It is important to be patient with investing. Investments do not always go up in a straight line, so if something is declining in value do not automatically ditch it. Look at the reasons why the price is falling and only consider selling if the investment case has negatively changed from when you bought it.

Consider each new investment in the context of what extra dimension it brings to the portfolio. You might find a new idea, but it might simply replicate what is already in your portfolio – so think long and hard before you initiate a new investment.

Finally, you incur trading costs each time you buy and sell, and these charges can add up if you are constantly making changes.