Allen & Overy Pension Scheme
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Understanding Investment Risk

Balancing risk and reward when you are deciding how to invest for retirement is important. If, for example your retirement is 20 or 30 years away, your investment decision should take into account potential for growth as well as security.

Broadly speaking there are four types of investment risk you need to think about when investing for retirement.

Capital value risk

This is the risk that the value of your investments can go down as well as up. Equities are normally the investment most affected by this risk, but virtually all investments can also fall in value, as they are also affected by changes in the economy and investment markets. If you invest in equity-based investments, the risk is that the value of your account may fall. If you are close to retirement, a fall in the value of your account may have a significant effect on the level of income and cash you can take. In terms of capital value risk, cash funds carry relatively low risk of falling in capital value.

Remember: Investments may go down as well as up.

Inflation risk

This is the risk that the value of investments will not grow quickly enough to keep up with rises in the cost of living (inflation). Even if your investment grows in value, if it does not grow in line with the cost of living, the 'real' value, or buying power of your account, will be less. Most funds can be considered to grow broadly in line with inflation in the long term, but some funds carry a greater risk than others. One way to reduce inflation risk would be to hold a particular type of UK government bond, called index-linked gilts that protect against inflation.

Remember: Investment growth should at least keep pace with inflation.

Missed-opportunity cost risk

In the past, higher risk investments such as equities have performed better than other investments over the long-term. Although there is no guarantee that higher risk investments will always give higher returns, generally in the past the riskier funds, such as equities, have grown more quickly and offered greater rewards than the less risky funds, such as cash.

If you choose to invest in lower risk funds such as cash and bonds as long-term investments, you can generally expect a lower pension.

As always, it is important to note that past performance is no guarantee of future performance.

Annuity price risk

When you retire you may choose to take part or all of your retirement income in the form of an annuity. How much this costs depends on the rates (or prices) set by the insurance company who sell you the annuity. You can get an idea of current annuity rates in the finance pages of the weekend press.

The cost of an annuity is set by annuity providers. However, annuity prices are usually set with reference to the price of bonds. Therefore, the higher the cost of bonds, the more your annuity costs and the less pension you can buy. However, if you have invested in bonds before you retire, the value of your account is linked to the price of bonds and hence typically also to the price of annuities. So, this means you have some protection against the cost of annuities rising, which would have the effect of increasing the amount of pension you can buy.

This means a suitable bond fund provides a reasonable degree of protection against annuity price risk. Funds investing in equities, property, cash and other non-bond investments may suffer from greater annuity price risk.

Remember: Certain types of investment are more closely linked to the cost of buying an annuity when you retire.

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