How do I Choose the Best Pension Asset Allocation?

John Lister

Pension asset allocation refers to both the way in which money invested to produce a retirement income is allocated, and the process and strategy that leads to these allocation decisions. Choosing the best pension asset allocation depends on the type of pension scheme in question. Individuals will usually follow a strategy of taking higher risks in the early years of the pension, then switching to more secure investments as retirement approaches. People operating a large-scale pension scheme, such as for the employees of a company, will usually carry out a pension asset allocation strategy that aggregates the individual approach, but also takes account of legal and financial requirements.

Woman with hand on her hip
Woman with hand on her hip

All forms of pension asset allocation aim to avoid going too far towards one of two extremes. An overly cautious approach will mean the pension fund grows so slowly that it offers little or no advantages over having simply saved the money in a risk-free format, beyond any tax benefits that may come with retirement savings. An overly risky approach runs the risk of the fund either outright losing money, or making so little profit that risk-free savings would have been a better option.

Most financial experts thus recommend pension asset allocation based on diversification. This refers to having a range of different investments in two senses. One is to have different types of investment, such as debt securities, equity securities, mutual funds, and property. Another is to have a wide range of individual investments of each type. For example, stock investments could cover individual stocks from different types of businesses, some stable and relatively secure, and others more high risk, plus index-based investments that perform in line with the stock market as a whole.

Another common recommendation for individual pension asset allocation is to change the strategy over time. In the early years, higher-risk investments are often favored; those that pay off will produce returns that have longer to grow, while those that don't pay off immediately can be left for longer in the hope of a recovery. In the years running up to retirement, most advisors favor switching to more secure investments such as government and securely-rated corporate bonds. This offers more predictability about the final pension that can be paid from the investments.

Corporate pension asset allocation is more complex as it tries to bring together the appropriate strategies for each individual. This means that the particular strategy in any one year will depend on the demographics of the workforce. Fund managers may also be influenced by accounting requirements. It may be necessary to include a high proportion of more secure investments, as this allows the company to show more certainty that the fund will be able to meet its liabilities.

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