How Pensions Work

Putting money into pensions can be a leap of faith, but I think it’s a leap we should make for our children with additional needs.  Sometimes our children are vulnerable financially, and while we may have short term plans for their finances, the long term one of a pension will happen after we’ve gone.  So I’m prepared to make that leap.

I regularly contribute to both my daughters’ pension funds.  For one it’s to give her a head start in life.  For the other with additional needs it’s to spread the risk so she will have enough to live on in later life – yes I’m a bit sad, and I have a 60 year plan.  But hey we’re in this special world, and I can share this because I have company in you.

In essence I’m putting my faith in a fund manager, who then defers the risk by using dollar/pound cost averaging.  Sounds very complicated but is easy because it all boils down to one word: automation.

Every month I transfer £40 to my daughter’s pension fund.  Every month the fund manager doesn’t think what shall I do with this £40, instead they use automation to buy stocks and shares for her pension.  Does this sound like a computer can do this?  It does, with the fund manager keeping an eye only on the bigger picture.

So let’s get down to dollar/pound cost averaging.  The purpose of it is to protect against stocks and shares being bought when the price is unusually high, when we don’t get value for our money. The drawback is we also don’t buy when the price is at its absolute lowest.  We buy at a fair average price.

How cost averaging works is by buying shares at the same time of each month regardless of price.  Each month my £40 is put to buying shares, and over a year the price paid averages out, because some shares are bought cheap and some are bought more expensive.

In any given year, the price of shares usually go up as well as down.  If I put 480 in my daughter’ pension fund on the first day of the year and prices were high, I wouldn’t get many units.  Let’s say the price was 1 per share; this would mean we could only buy 480 for the year.

But instead of putting all that money in the pension all at once, but I put in 40 each month, my daughter might get a different result.  In the first month the price was high at 1 per share, so we could only buy 40 that month.  Three months later the price might have dropped to 50 pence a share, so would could buy 96.  If the price remained like this for 6 months and then went back up to 1 per share, then over the year we might have bought 720 shares for out that same 480 instead of 480.

The opposite could also work true.  After the first month prices could go up, and keep going up.  Then we would have bought less shares over the year.

But the real point is spreading the purchases over the year in an automated fashion reduces the risk of paying too much in any given month.  This means we are more likely to buy shares at their average price for the year, rather than at their cheapest or most expensive.   And that is the point of dollar/pound cost averaging: to make sure we buy our shares at the average price over the year because we are not looking to sell them for a quick profit.  Pension funds work by holding shares for a long time.  They work on the old adage of: its time in the market, not timing the market.