How do pension funds usually invest?

A pension plan is a type of retirement plan that requires employers to contribute to a pool of funds reserved for workers’ future benefits. The fund pool invests on behalf of employees, and the investment income brings income to workers when they retire. Pension fund assets need to be carefully managed to ensure that retirees receive the promised retirement benefits. For many years, this meant that funds were limited to investments mainly in government securities, investment-grade bonds and blue chip stocks.

Changing market conditions — and the need to maintain a sufficiently high rate of return — have resulted in pension plan rules allowing investment in most asset classes. These are some of the most common investments in which pension funds allocate large amounts of capital. Here, let’s take a look at some of the asset classes that pension funds may have.

Key points

  • The pension fund assets must be managed for the purpose of ensuring that eligible retirees receive the promised benefits.
  • Until recently, pension funds invested mainly in stocks and bonds, usually using debt matching strategies.
  • Today, they are increasingly investing in various asset classes, including securities such as private equity, real estate, infrastructure, and gold that can hedge against inflation.

Pension plans, also known as defined benefit plans, ensure that employees receive a fixed amount of expenditure regardless of their investment performance.

Fixed income investment

U.S. Treasury bonds and investment-grade bonds remain a key part of pension fund investment portfolios. Investment managers seeking higher returns than conservative fixed-income instruments have expanded to high-yield bonds and safe and reliable commercial real estate loans. Investment portfolios including asset-backed securities (ABS) such as student loans and credit card debt are increasing. However, the risks associated with these securities are often much greater than typical corporate or government bonds.

As an example of the prevalence of fixed-income securities in pension investment portfolios, the California Public Employees Retirement System (“CalPERS”), the largest pension plan in the United States, seeks an annual rate of return of 7%.As of March 2020, approximately one-third of its $385.1 billion investment portfolio is allocated to fixed income investments.

stock

Equity investments in US blue-chip common stocks and preferred stocks are the main investment categories of pension funds.Managers have traditionally focused on dividends combined with growth. The search for higher returns has pushed some fund managers into riskier small-cap growth stocks and international stocks.

Larger funds such as CalPERS manage their equity portfolios on their own. Smaller funds may seek external management—or invest in the same institutional versions of mutual funds and exchange-traded funds (ETFs) as individual investors. The main difference here is that the institutional stock category has no front-end sales commission, redemption or 12b-1 fees, and they charge a lower fee ratio.

Private property

Institutional investors such as pension funds and investors classified as qualified investors invest in private equity-a long-term alternative investment category suitable for mature investors. In fact, pension funds are one of the largest sources of capital in the private equity industry.

In its purest form, private equity represents a managed fund pool that invests in equity in a private holding company, and its purpose is to ultimately sell the investment to obtain considerable returns. Private equity fund managers charge high fees based on promises of higher than market returns.

US$8.6 trillion

According to data from the Institute of Investment Companies, the number of assets under management of U.S. public and private sector pension plans at the end of 2018.

real estate

Pension fund real estate investments are usually passive investments made through real estate investment trusts (REITs) or private equity pools. Some pension funds set up real estate development departments to directly participate in the acquisition, development or management of real estate.

Long-term investment in commercial real estate, such as office buildings, industrial parks, apartments or retail complexes. The goal is to create an asset portfolio that combines the appreciation of stocks with rising incomes adjusted for inflation to balance the ups and downs of the market.

infrastructure

Infrastructure investment is still a small part of most pension plan assets, but they are a growing market involving various public or private development projects for electricity, water, roads, and energy. Due to the budget and the borrowing capacity of the civil authorities, public projects are restricted. Private projects require large amounts of capital and are either expensive or difficult to raise. Pension plans can invest in longer-term prospects and the ability to build creative financing.

Typical financial arrangements include payment of basic interest and capital to the fund, and some form of income or equity participation. In addition to financing payments, toll roads may pay a small portion of tolls. If another company buys the power plant, the power plant may pay a small fee for every megawatt produced and a certain percentage of profits.

Inflation protection

Inflation protection is a term used to refer to assets whose value tends to rise as inflation increases. These may include inflation-adjusted bonds (such as TIPS), commodities, currencies, and interest rate derivatives. The use of inflation-adjusted bonds is usually reasonable, but the increased allocation of pension fund assets in commodities, currencies, or derivatives has caused some people’s concerns because they bring additional special risks.

Debt matching, also known as “immunization”, is an investment strategy that matches future asset sales and income flows with expected future spending time. This strategy has been widely accepted by pension fund managers, who try to minimize the liquidation risk of investment portfolios by ensuring that asset sales, interest and dividend payments are consistent with pensioners’ expected payments. This is in contrast to simpler strategies that try to maximize returns regardless of exit time.

For example, retirees who live on income from investment portfolios usually rely on stable and continuous payments to supplement social security payments. The matching strategy will involve the strategic purchase of securities to pay dividends and interest on a regular basis. Ideally, the matching strategy should be in place before the start of the retirement year. Pension funds will adopt similar strategies to ensure that their welfare obligations are met.

Bottom line

The pension fund makes a promise to its participants to ensure that they will have a certain level of retirement income in the future. This means that they must be relatively conservative in terms of risk, but also get enough returns to pay for these guarantees. Therefore, fixed-income securities often form a large part of pension investment portfolios together with blue chip stocks. More and more pension funds are seeking additional returns elsewhere in real estate and alternative asset classes, even though these components are still a relatively small part of their investment portfolios.

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