Diversification. Annuity. Compound interest. Three terms that sound complicated but don’t have to be.
Understanding financial jargon shouldn’t require a degree in economics. Yet these words come up in almost every conversation about pensions and investments and it is easy to nod along without being sure what they mean. Understanding your options is an important part of making informed decisions, so here they are in plain English.
One of three
Diversification
In short: not putting all your eggs in one basket.
Diversification means spreading your money across different types of investment, such as shares, bonds, property and cash. It also means spreading across different companies, industries and countries. Different investments tend to rise and fall at different times, so a fall in one part of a portfolio may be cushioned by another.
Diversification does not stop a portfolio falling in value. What it does is reduce the chance that one company, sector or country going wrong does serious damage to your plans.
Two of three
Annuity
In short: swapping some or all of a pension pot for a guaranteed income.
An annuity is a product you buy from an insurance company with money from your pension. In return the insurer pays you a regular income, either for the rest of your life or for a fixed number of years.
- The appeal: certainty. You know what will arrive each month, however long you live and whatever markets do.
- The trade-off: once bought, an annuity generally cannot be cashed in or changed.
- What affects the income: your age, your health, interest rates at the time you buy and options such as an income that rises each year or continues to a partner after your death.
An annuity is one of several ways to take a pension income. Many people now combine it with drawdown, where the pot stays invested. Which suits you depends on your other income, your health and how much certainty you want. Our page on retirement and pensions explains the options.
Three of three
Compound interest
In short: earning a return on your returns.
When interest or investment growth is added to your money and left there, the next year’s return is earned on a bigger amount. Over time that snowball effect can make a large difference.
£10,000 growing at a steady 5% a year becomes £10,500 after one year and £11,025 after two. After ten years it is about £16,289 and after twenty years about £26,533, even though nothing more was added.
Compounding works on costs too. Charges and inflation compound in the same way, which is why both matter over the long term. Real investments do not grow at a steady rate and can fall.
We have written more on this in compound interest: is it really the most powerful force in the universe? and you can try different figures in our cashflow modelling calculator.
Good financial advice should leave you feeling informed, not confused.
Ask us anything
If a word in a letter, a pension statement or a conversation has left you unsure, ring us on 01772 864314. We would rather explain something twice than have you make a decision you do not fully understand.
Want to talk this through?
A free introductory call with an adviser. No obligation afterwards.
This article is for general information only. It is not personal advice and it is not a recommendation. The value of investments and the income from them can fall as well as rise and you may get back less than you invested. Past performance is not a reliable indicator of future results. Tax treatment depends on individual circumstances and may change. Fernleigh Wearden & Company Ltd is authorised and regulated by the Financial Conduct Authority, firm reference number 929372.
