How does a pension fund act as an investor?
Pension funds, also called superannuation funds in some countries, are any plans or funds that pay for workers’ retirement. These investment funds pool monetary contributions from pension plans set up by employers, workers unions, and other organization into capital markets, both public and private such as the bond and stock markets, for purpose of generating profits.
Pension funds account for the largest blocks of investment in most countries and often dominate the stock markets. These funds are exempt from taxes and the profits from their investments are also tax exempt or tax deferred.
Types of Pension Funds
There are two major types of pension funds. The first type of pension fund is the defined benefit fund, which is what most people think of when they talk about pension. The second type of pension fund (called the defined contribution plan) is something most people are familiar with – the 401(k) plan.
Defined Benefit Fund
A defined benefit fund pays a fixed amount of money to beneficiaries, regardless of whether the investment funds perform well or not. Fund managers usually invest in these contributions conservatively and have to beat the inflation without losing out on their principal amount.
If the pension funds do not perform well, the employer must earn enough to compensate any shortfall. This is similar to annuity issued by an insurance company. The employers must bear all the risks if the stock market drops. This is the main reason why many companies have stopped offering defined benefit funds to their employees.
Defined Contribution Plan
The second type of pension plan is the defined contribution plan, which includes the common 401(k) plans. This pension fund pay out employee benefits depending on how well the investment performs.
In these pension plans, employees, rather than the employers, bear the burden of all the risk. This shift in the risk is the biggest difference between these plans.
Single-Employer or Multi-Employer Pension Schemes
In the United States, pension funds can be either single-employer or multi-employer.
Multi-employer pension schemes allow small companies to join forces and create diversified investment portfolios. This is very beneficial to the employees as they can change companies without losing their pension benefits.
According to the Pension Benefit Guaranty Corporation, there are about 10 million retired and current workers in multi-employer plans. However, by 2025, this program will save insolvency as 130 multiemployer plans will run out of money by 2040.
Additionally, the single-employer plan covers 28 million workers. Although it is currently in deficit, it is expected that it will recover its losses sooner than anticipated.
This federal government agency guarantees the profits from these plans, which ensures pension incomes for 35 million workers.
Where Do Pension Funds Invest?
Pension funds usually operate through portfolio diversification and prudence, investing their money to various investment instruments like bonds, stocks, derivatives, and alternative investments.
However, once, they were only restricted to investing in government-backed securities like investment-grade bonds with high credit rating and blue chip stocks. However, since then, thanks to the changing market conditions and the necessity to maintain high rates of return, pension investments have now been allowed in majority of the asset classes.
Mentioned below are some of the most common classes in which people invest in pension funds.
Another type of major investment is equity investment in the United States’ blue chip stocks, both common and preferred. The focus of fund managers is on dividends as well as growth. To get better returns, some pension fund managers have also dipped their toes into riskier small-cap growth stocks and international equities.
Larger pension funds like CalPERS manage their own portfolios. However, smaller funds invest in the same types of mutual funds and exchange traded funds as private individual investors. The difference is that these institutional versions charge a low expense ratio and do not offer front-end sales commissions or 12b-1 fees, or redemption fees.
Private Equity Investments
Private equity investments are becoming an increasingly popular part of a pension fund portfolio. In simple terms, private equity is a long-term alternative investment into private companies made by experienced investors, with the intention of selling the investment in return of gains. This is done by cashing out the business once it becomes mature enough to generate significant profits.
Private equity fund managers charge a higher fee in return of higher returns.
Pension funds still actively invest in U.S. Treasury securities and investment –grade bonds. Fund managers who are looking for opportunities to get higher returns than what they can get from conservative investment plans have now expanded their reach to high-yield bonds and secured loans of commercial real estate.
Additionally, asset-backed securities including credit card debt and student loans are now newer investment tools which have proven to improve the overall returns of a pension fund.
The California Public Employees’ Retirement System (CalPERS) has a $385.1 billion portfolio, boasting an annual return of almost 7%. About 29 percent of this portfolio was allocated to income investments, according to a March 2020 report.
Real Estate Investment Trusts
Real estate investment is also very popular among pension fund managers. These are passive investments made through real estate investment trusts (REIT). Some pension funds manage real estate development departments so that they can participate directly in acquiring, developing and running properties.
Commercial real estate, including office buildings, apartment complexes, retail buildings, and industrial parks, also provides you long-term investments. The main aim is to develop a portfolio of real estate properties that offer equity appreciation along with a rising income adjusted for inflation so that it can balance the fluctuations of the market.
Infrastructure investments account for only a small share of pension fund portfolio but the market is increasingly growing and offers a diverse assortment of private and public developments including power, energy, water, and roads.
Private projects require large funds and are too expensive and challenging to raise. Public projects also experience limitations because of small budgets and relies on borrowing power of civil authorities. Pension funds can still invest in these plans with an outlook of long-term investments and the ability to be a vast resource of innovative funding.
Typical financial agreements in these types of investments include a base payment of interest and capital to the fund as well as equity participation or some revenue. For example, a power plant may pay a little amount every time it generates a megawatt of electricity. It also pays back a percentage of the profit if another company acquires the plant.
This is an umbrella term that covers a lot of investment instruments like inflation-adjusted bonds, derivatives, currencies, and commodities. Although it can be quite profitable to invest in inflation-adjusted bonds, the rest of the instruments carry higher risks and it may not be very prudent to invest too frequently or too much in these.
Asset management companies these days are offering mutual funds that engage in these kinds of investments.
So exactly how does a pension fund act as an investor? Well, as one of the largest investment capital providers, pension funds can leverage their huge pool of money to deliver positive economic and social impacts. The benefit of pension plans depends almost entirely upon understanding how it works.
As you see above, pension plans now have the freedom to invest in a number of asset classes. However, some instruments are more profitable and less risky than others. Therefore, you need to know how much you can afford to invest. Still, even risky asset classes show promise of generating profits. This is if they have a sustainable source of funding, like infrastructure investment.