How to pick the best policy for a personal pension

Dido Sandler looks at the different merits of unit-linked and with-profits policies

So you've finally heeded the advice and decided to take the pensions plunge. You now have to work out where to invest your hard-earned savings.

If you opt for a personal pension you will have a wide investment choice, both in terms of the company you choose and the type of fund in which you invest. You will be faced with two main types of investment vehicles: with-profits and unit-linked funds.

With-profits is a safety-first investment vehicle. It protects investors from the harshest swings of the stock market by having a "smoothing" effect on investments. So if the markets have a particularly bad year, the effects are averaged out over the term of the policy.

The mechanism that ensures this smoothing effect is the bonus system of payouts. This means filling an individual's pot with a proportion of the fund's growth on an annual basis, and the rest as a final or "terminal" bonus. Annual bonuses are guaranteed - they cannot be taken away from the pension pot.

The investment strategy that underpins with-profits funds is relatively cautious, and the returns may be more limited than those of unit-linked funds. This is because the system of annual bonuses requires a significant proportion of money to be invested in gilts - government loan stock with typically low risk and low yields.

Mike Baugh, head of research with DBS, a network of independent financial advisers, says: "People with short investment terms, that is 10 or so years, are probably better off with with-profits plans because these afford more protection against the vicissitudes of the stock market. Over a longer period, the markets tend to even themselves out, so the protection afforded by with-profits is not as important."

Don Clark, managing director of Wolverhampton-based advisers Torquil Clark, adds: "Individuals with longer to go until retirement should go for maximum growth by buying into unit-linked funds." But he warns: "If Trevor McDonald announcing on the 10 o'clock news a fall in the FTSE 100 of 200 points makes you have sleepless nights, stick to with-profits."

Choosing the best with-profits fund is a tricky business. Bob Marriott, research manager at Sedgwick Noble Lowndes, says: "If the free asset ratio - or the proportion of assets to liabilities - in a fund is high, this should lead to better future returns."

The returns, and the effect of charges, are more transparent with unit-linked funds. The structure is similar to unit trusts', in that the saver's cash buys into units in a collective investment fund. This is often a "managed" or "balanced" fund, which contains a mix of a broad range of investments.

Managed funds are seen as relatively safe because of this spread, although they are more risky than with-profits because a smaller proportion of the money is invested in gilts.

But managed funds are not the only option. Life companies have many funds to choose from. National Mutual, for example, has an overseas equity fund, a UK equity fund, property, new Far Eastern, USA and Japanese funds, as well as a deposit fund. So individuals have a greater choice with unit-linked. But they also need a greater degree of confidence to be able to switch money between managers.

Factors influencing investment decisions include performance and prospects for specific sectors, and changing needs. If you are within five years of retirement, you may decide to switch over to a gilts-based or deposit fund, to avoid any last-minute market volatility imperilling your pension pot. Most providers offer customers a phased transfer service, which eases them gently into lower-risk investments.

Dido Sandler is a journalist at 'Financial Adviser'.