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Simply put, a pension fund or a pension pot is basically a pot of money that provides retirement income. So, when you and I retire, we’re going to need to live off the money. We might have saved up but right now when we are working, we can invest money into our retirement and that is where a pension fund comes in. It is a large sum of money that is being invested in order to pay you and me when we retire.
Pension funds often pool huge sums of money to be invested in capital markets like the stock and bond markets, in order to produce profit (returns). It represents an institutional investor that invests substantial sums of money in both private and public corporations. The primary purpose of a pension fund is to ensure that there will be enough money to cover employees’ pensions after they retire in the future.
The rise of pension funds
The “unseen revolution” altering corporate ownership in the United States is now evident to all, fifteen years after it was first documented. Around one-tenth of the equity capital of America’s publicly owned corporations is held by the 20 largest pension plans (13 of which are pensions of state, municipal, or nonprofit employees). In total, institutional investors — most notably pension funds — own over 40% of the common stock of the country’s large (and many medium) corporations. Public employee pension funds, which are the largest and fastest expanding, are no longer willing to be passive investors. They are increasingly demanding a say in the companies in which they invest, such as veto power over board appointments, executive salaries, and key corporate charter elements. Pension funds also control over 40% of the medium- and long-term debt of the country’s larger corporations, which is still widely disregarded. As a result, these institutions have become both the largest lenders and owners of corporate America. For years, finance texts have highlighted that the lender’s power is equal to, if not greater than, that of the owner.
One of the most dramatic power swings in economic history is the rise of pension funds as dominant owners and lenders. General Motors developed the first modern pension fund in 1950. Pension funds now have $2.5 trillion in assets, split about evenly between common stocks and fixed-income instruments, after four decades. These assets will continue to increase aggressively for at least another ten years, according to demographics. In the 1990s, unless there is a prolonged depression, pension funds will have to invest $100 billion to $200 billion in new resources per year.
Types of pension funds and its difference
There are two key types of pension funds. The first type is Defined contribution and the second type is Defined benefit.
Regardless of how well the fund performs, a defined benefit fund distributes a fixed income to the recipient. The employee contributes a set amount to the fund. These donations are invested prudently by the fund managers. They must outperform inflation while not losing the principal. The fund management must make a sufficient return on investment to cover the benefits. Any gap must be covered by the employer. It’s similar to an insurance company’s annuity. In this instance, the employer acts as the insurance company, bearing all of the risks if the market falls. Because of this risk, several firms have discontinued offering these policies.
In a defined contribution plan, the employee’s rewards are determined by the performance of the fund. 401(k)s are the most common of them. If the fund’s value falls, the employer is not required to pay out defined benefits. The employee assumes all of the risks.
The most significant distinction between a defined benefit and a defined contribution plan is the risk shift. The defined benefit is being rolled out because it is old school. Defined contribution on the other hand is around for the most part today. Most employers, companies, and individuals are likely to be on defined contribution pension schemes.
Country-wise comparison of pension funds
Globally, the quality of pension systems accessible to workers varies substantially. According to the Mercer CFA Institute Global Pension Index 2020, the Netherlands has the best system, whereas the United States is nowhere near the top.
· Netherlands: Its retirement income system is based on a flat-rate public pension and a semi-mandatory occupational pension tied to wages and collective bargaining agreements. The majority of employees in the Netherlands are members of these occupational plans, which are defined-benefit plans that are industry-wide. Earnings are based on an average over a lifetime.
· Denmark: Denmark features a public basic pension system, an income-related supplementary pension benefit, a fully funded defined-contribution plan, and required occupational pension plans.
· Israel: The retirement income system in Israel is made up of a universal state pension as well as private pensions with the mandatory employee and employer payments. Annuities are typically paid via the private pension system.
How pension fund diversifies its investments
By shifting their concentration to other assets, pension funds can protect themselves from a stock market meltdown. Most pension funds have typically sought growth by investing in shares, but with global stock market valuations so high, the short-term outlook appears dismal. Alternative assets, such as private credit, private equity, and real assets, may outperform a standard growth portfolio on a risk-adjusted basis.
Investors are shifting their focus to alternative credit investments in search of yield due to low bond rates and scheme demographics. As contributions fall, a growing number of schemes become cash flow negative, putting an emphasis on income-generating assets while requiring forced sales of growth assets.
Because interest rates on traditional assets like gilts and investment-grade bonds are so low, trustees are looking into alternative credit markets like high yield, private lending, royalties, and long-term leasing.
Performance of pension funds during the financial crisis
- The funds’ investment performance all suffered in the early aftermath of the pandemic’s outbreak. Their returns, on the other hand, have fared “significantly better” than they did during the global financial crisis when they fell far short of their standards.
- The funds’ ability to withstand shock was aided by the swift and unprecedented monetary and fiscal support provided in response to the rapid spread of Covid-19. However, improvements in the asset class mix and risk management capabilities of the funds also contributed to the funds’ ability to withstand shock.
- Since the financial crisis, pension funds have extended their exposure to alternative asset classes such as private equity, infrastructure, and real estate, which has helped to mitigate the risk of their public assets.
- In addition, the robust liquidity positions of pension funds have helped to protect them from market volatility.
- During the market upheaval in the first half of 2020, these funds had minor liquidity stress, in contrast to the previous financial crisis. We feel that since then, advances in risk management governance mechanisms have been effective in protecting funds from market volatility.
Inflation protection refers to assets that tend to appreciate in value when inflation rises. Inflation-adjusted bonds (such as TIPS), commodities, currencies, and interest-rate derivatives are examples of these. Although the use of inflation-adjusted bonds is frequently justifiable, some have expressed worry about the greater allocation of pension fund assets in commodities, currencies, or derivatives due to the additional idiosyncratic risk they represent.
Liability matching, sometimes known as “immunisation,” is an investing technique that compares the timing of predicted future expenses to the timing of future asset sales and revenue streams. The method has gained traction among pension fund managers, who use it to reduce the risk of a portfolio’s liquidation by matching asset sales, interest, and dividend payments to planned pension payments. This is in contrast to simpler techniques that aim to maximise return regardless of when withdrawals are made.
To supplement social security payments, pensioners living off the income from their portfolios, for example, rely on secure and consistent payments. A matching strategy would entail buying stocks strategically in order to receive dividends and interest at regular periods. A matching strategy should ideally be in place well before the retirement years begin. To ensure that its benefit commitments are met, a pension fund would use a similar technique.
Pension fund driving sustainable investing
Pension funds might be a powerful force in persuading businesses to embrace ESG goals such as tackling climate change and increasing employment justice. However, they must balance these objectives with their fiduciary responsibility to protect their members’ retirement savings. They must also overcome obstacles in the United States, such as gaps in ESG adoption measurements and misunderstanding about government restrictions on such investments. According to the paper, total assets managed by U.S. institutional investors using ESG principles have increased significantly over the last 15 years, reaching $6.2 trillion in 2020, with public pension funds accounting for more than half of that (54%). Climate change and war risks in terrorist or repressive regimes have recently risen to the top of investors’ concerns, followed by tobacco usage, corporate governance, and sustainable natural resource and agriculture practices. Investors’ appetites for ESG principles, on the other hand, oscillate between extremes.
According to the Wall Street Journal, ESG fund investors are moving their focus from growth to value companies, while other institutional investors are “lining up trillions of dollars to support a shift away from fossil fuels.”
Conservative risk measures
Pension funds make guarantees to their members, ensuring that they will be able to retire with a particular level of income in the future. This means they must be risk-averse while simultaneously generating sufficient returns to cover the guarantees. As a result, together with blue-chip stocks, fixed-income instruments make up a large portion of pension portfolios. Pension funds are increasingly looking for additional returns in real estate and alternative asset classes, albeit these assets still make up a modest portion of their overall portfolios.
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