One of pensions’ great conundrums is the question of whether the size of contributions or investment performance has the greater impact on the size of the pension pot. Hargreaves Lansdown has researched this very point, but its answers are not without controversy.
Hargreaves Lansdown has researched this very point but its answers are not without controversy. Its modelling shows that if trustees can boost returns by 1 per cent, even though contributions stay the same, this could increase members’ pots at age 68 by more than £55,000 in today’s money, compared with around £23,000 if annual contributions are a percentage point higher but investment returns remain the same.
The research starts from a baseline position of simply paying in 8 per cent (soon to be the auto-enrolment minimum) and receiving an annual return of 5 per cent, while paying a charge of 0.75 per cent. Contributions increase each year by 2 per cent to reflect pay rises, and inflation is 2 per cent.
Our chart confirms the staggering difference just slight tweaks can make. After 552 months (46 years), by increasing contributions by just 1 percent, the end pot size will be £522,809 instead of £464,719. If returns went up by 1 per cent, that would increase the pot size to £603,429.
If both contributions and investment returns went up by 1 per cent, the ultimate pot size would be a massive £678,857. If contributions went up to 12 per cent, in line with the Pension and Lifetime Savings Association’s ‘Hitting the Target’ campaign, a pot of £905,143 would result from annual returns of 5 per cent.
Default performance under spotlight
Of course, the uncertainty of investment means higher returns are not a tap members can turn on in the same way as contributions, but it does show the importance of picking the right fund.
Indeed, most popular funds actively chosen by workplace pension members have beaten the average return of default funds by 4.08 per cent a year over the past five years, according to Hargreaves Lansdown.
The 10 most popular funds chosen by pension members have outperformed the average default fund over one, three and five years.
Nathan Long, senior analyst at Hargreaves Lansdown, says this is down to the default funds’ lower average equity weighting. He says a larger stock market allocation “should deliver better long-term returns for active investors, although they are likely to see more fluctuations in the short-term value of their pension.”
Don't ditch defaults yet
But tread warily, says David Robbins, senior consultant at Willis Towers Watson, who points out that if the funds selected by Hargreaves have been given equal weighting, they may be skewed by size or dragged up or down by the best and worst performers.
He also questions whether the statistics show default funds in their pure growth phase, or whether returns are impacted by the derisking quite rightly undertaken as members approach retirement.
Robbins adds: “If the small proportion of people making their own choices have done better, this does not mean millions of others could easily have done the same, especially if success was driven by a risk/return trade-off and non-selectors had a lower risk tolerance.”
Fiona Tait, technical director at Intelligent Pensions, says: “Default funds are a one-size-fits-all solution: in practice, you could almost certainly find something that better suits your own circumstances and objectives. That said, picking a fund requires specialist knowledge and skill and for those who don’t have access to financial advice, a default fund from a professional manager should at least help to avoid any major investment errors.”
