Don’t be shy, ask ii…which low-cost ETFs should I put in my pension?

No question is a stupid one, so whether you want to find out what you need to do to start investing or how the stock market works, don’t be shy, ask ii. Email yours to: ask@ii.co.uk

Mr Kumar asks: can you please help me identify some top global index funds (low cost, better returns) which might be suitable for a pension?

Kyle Caldwell (pictured above), collectives editor, interactive investor, says: many pension savers that choose to not make their own investment decisions will find themselves in a ‘lifestyle strategy’ default fund – picked by the pension provider. Such funds in the early years of pension saving, during the first couple of decades, invest in higher risk assets that have the best growth potential (mainly company shares). When retirement nears (typically in the last five to 10 years of working life) the underlying investments become more cautious and lower risk, like bonds and cash.

• Read about: SIPP Portfolio Ideas | How SIPPs Work | Top ETFs

Such funds, however, are arguably no longer fit for purpose. They were a sensible strategy when most retirees bought annuities in exchange for a guaranteed pension income for life. Switching to more cautious investments avoided a scenario of the pension pot falling sharply in value ahead of converting into an annuity – with no chance for the investments to recover.

Nowadays, since the advent of pension freedoms legislation in 2015, many people now invest throughout their retirement. Therefore, if you are 47 and a decade away from being able to access your pension (when the rules change from 55 to 57 in 2028) you may instead prefer to keep your pension mainly invested in equities so as to not miss out on the potential higher investment returns.

You may also be planning to retire later than 57, and instead closer to the current state pension age of 66. For those in this position - given the investment time horizon would be 20 years – it makes more sense to invest for growth rather than moving to cautious investments.

Therefore, those who are planning to keep their money invested during retirement may be better off building their own pension fund to make their own asset allocation decisions. A big benefit is that they will be in control of deciding how much of their pension to put in high growth investments – such as equities.

One way to go about this is to invest in index funds and exchange-traded funds (ETFs). Such funds offer investors cheap, simple and effective exposure to global stock markets and themes. A passive fund tracking the US or UK market, for example, can be bought for a charge of less than 0.1% a year, which is £10 on a £10,000 investment.

• Active versus passive funds: a beginner’s guide
• Active versus passive: a brief introduction
• Why investors are retreating to passive funds as markets fall

Passive fund fees are likely to be much cheaper than lifestyle default funds which have a charge cap of 0.75%. The cost savings is another benefit, alongside the potential extra growth (including the power of compound interest) the pension will produce through being invested in equities for longer.

A passively managed multi-asset fund may fit the bill as an alternative to lifestyle strategy default funds. Two popular fund ranges that invest in index funds are Vanguard LifeStrategy and BlackRock MyMap, available through interactive investor here. The respective fees per year are 0.22% and 0.17%. Both are comprised of funds with different equity weightings – ranging from 20% to 100%. The balance is mainly made up of bonds. Investors could therefore implement their own lifestyle strategy – reducing risk when they see fit by switching to a fund with a lower amount in equities.

Build your own portfolio

Alternatively, investors could build their own passive multi-asset fund. This would require time, dedication and accepting that there will be more trading costs – given that holdings would need be rebalanced from time to time. However, it does give an investor greater control.

For the equity exposure, candidates that would make good core holdings are those that provide few surprises by being thoroughly diversified - one of the golden rules of investment. 

Diversification is achieved through mixing a range of stock market investments with other investment types, primarily bonds. However, it may be worth considering some exposure to alternative investments - such as property, private equity and infrastructure. 

The theory is that different types of investments are unlikely all to outperform or underperform at the same time, which therefore reduces the volatility of your overall portfolio. 

For equity exposure a global index fund or ETF would be worth considering to be held alongside US and UK trackers.

One of the cheapest global passive options is L&G Global Equity ETF (LSE:LGGG), which has a yearly fee of 0.1%. It tracks the fortunes of 1,665 companies - so is therefore highly diversified. 

Two other low-cost passive products, with a yearly fee of 0.12%, are SPDR® MSCI World ETF and Lyxor Core MSCI World ETF. Both track the MSCI World Index, composed of around 1,500 companies across 23 developed markets.

For the UK and the US there are various options available – with many priced at 0.1% or below.

Exposure to the FTSE 100 can be gained through iShares Core FTSE 100 ETF and HSBC FTSE 100 ETF, which both charge 0.07%. To back mid-cap shares, which tend to have a greater domestic focus than companies in the FTSE 100, one option is Vanguard FTSE 250 UCITS ETF, which costs 0.1%. 

For the US, Vanguard S&P 500 UCITS ETF is popular among interactive investor customers. It has a yearly fee of 0.07%. Tracking the same index and for the same fee is iShares Core S&P 500 ETF.

For those considering specific exposure to US tech shares options include Invesco EQQQ NASDAQ-100 ETF or iShares NASDAQ 100 ETF. The fees are 0.3% and 0.33%. 

US smaller company shares options include SPDR® Russell 2000 US Small Cap ETF or L&G Russell 2000 US Small Cap ETF, which both cost 0.3%.  

The cheapest funds across all the main markets can be found in our guide here.

• How much should I have in my pension?
• Think before dipping into your pension
• Pension blind spots cost an average of £120K over a working life

As well as the fund charge, it is worth looking under the bonnet to find out which index the passive fund is seeking to replicate – it won’t necessarily be the FTSE All Share or S&P 500. Also check out the tracking error percentage, which reflects how efficiently the passive fund or ETF has followed the performance of the index they track over time.

For bonds, a passive option in interactive investor’s Super 60 list of rated funds is Vanguard Global Bond Index, which has a fee of 0.15%. It invests in around 12,000 bonds.

Alternatively, investors may wish to consider active funds. Unlike stock market passive funds that tend to buy more of companies as they grow larger (and more successful), bond funds have their biggest positions in companies or countries with the most debt. Active options in the Super 60 include M&G Global Macro Bond and Jupiter Strategic Bond. The charges are 0.63% and 0.73%.

As mentioned above, it is also worth considering some exposure to alternative investments alongside bonds for this part of the portfolio. 

Investment pathways 

Those who withdraw some of their pension savings but are unsure about how to invest the rest could consider ‘Investment Pathways’, which are four investment options. The initiative from industry regulator, the Financial Conduct Authority, is designed in part to address concerns that people entering or in retirement are placing their funds into cash and missing out on years of investment growth in the process, leaving themselves at greater risk of running out of money in retirement.

The idea is that by following the Pathway that most closely matches someone’s retirement goals, those who are less confident making investment decisions will be able to remain invested in the stock market but without having to face the personal responsibility of the right fund choices.

Interactive Investor Investment Pathways