Most people encounter pension funds through workplace retirement plans, such as the 401(k) in the United States or workplace pensions in other countries. Your employer may offer several different fund options. You need to choose one or more of them. This choice will affect your quality of life decades from now.
The first step in choosing a pension fund is understanding your time horizon. If you are thirty years away from retirement, you have a long time for your money to grow. You can afford more market volatility because you have plenty of time to wait for markets to recover. If you are only five years away from retirement, you need to be more conservative. You do not have time to recover from a severe market drop. Your time horizon determines whether you should choose an aggressive or conservative fund.
A rough guide for time horizons works like this. If you are more than twenty five years from retirement, you can choose a fund that is mostly stocks. Stocks have high long-term returns but high short-term volatility. You have enough time to wait. If you are fifteen to twenty five years from retirement, choose a fund that mixes stocks and bonds. Stocks provide growth. Bonds provide stability. If you are five to fifteen years from retirement, increase your bond allocation and decrease your stock allocation. If you are less than five years from retirement, your focus should be on protecting what you have already saved, rather than chasing more growth. A fund focused on bonds and cash is more appropriate.
But this is just a rough guide. Your risk tolerance also matters. Some people, even when thirty years from retirement, cannot handle the psychological pressure of a thirty percent stock market drop. If they panic and sell, they turn a paper loss into a real loss. If you are in this group, choosing a more conservative fund is reasonable, even if the long-term return is somewhat lower. Sleeping well at night is more important than chasing the highest possible return.
The second step in choosing a pension fund is understanding fees. Pension fund fees are typically expressed as an expense ratio. This is the percentage deducted from your fund assets each year. One percent sounds small. But over forty years, one percent in fees eats a huge portion of your retirement assets. For example, suppose you contribute ten thousand dollars each year for forty years, earning six percent annual returns. With an expense ratio of 0.1 percent, you end up with about 1.6 million dollars. With an expense ratio of 1 percent, you end up with only about 1.3 million dollars. The difference of 0.9 percent costs you about three hundred thousand dollars over forty years. So choosing low-fee funds is very important.
The third step is understanding fund types. Actively managed funds are run by fund managers who decide which stocks or bonds to buy. Their goal is to beat the market. Passively managed funds simply track a market index, such as the S&P 500. They do not try to beat the market. They just copy it. Historical data shows that most actively managed funds fail to beat passively managed funds over the long term, and active funds have higher fees. For most pension investors, passive index funds are the better choice.
The fourth step is considering target date funds. These funds have a year in their name, such as “Target Date 2055 Fund.” The design concept is simple: you just pick the fund with the year closest to your planned retirement. The fund automatically adjusts its asset allocation over time. When you are young, it holds more stocks and fewer bonds. As you age, it gradually reduces stocks and increases bonds. You do not need to make any adjustments yourself. For people who do not want to manage their own pension investments, target date funds are an excellent choice. Their fees are typically lower than active funds but slightly higher than pure index funds.
The fifth step is not switching funds frequently. Every switch may incur fees and taxes. More importantly, frequent switching often comes from chasing past performance. People see that a fund went up a lot last year and switch into it. But last year’s winners are rarely next year’s winners. The secret to long-term success is choosing a fund that fits you and then sticking with it for decades.
Choosing a pension fund is not a one-time task. You should review it once a year to make sure your choice still fits your situation. If you change jobs, or your risk tolerance changes, or you get closer to retirement, you may need to adjust. But once a year is enough. Checking every day will only make you anxious.
Your pension fund is the foundation of your retirement life. Taking time to understand it and choose it is one of the most important financial decisions you can make for yourself. Do not put this decision off until “later.” Later comes faster than you think.
