Pension fund
Pension fund is a financial arrangement or institutional pool of assets established to finance pension benefits for individuals during retirement. Pension funds collect contributions from employers, employees, governments, or other sources and invest those funds in financial or other assets to generate resources for future pension obligations.
Pension funds are important institutional investors in financial markets and may invest across asset classes such as equities, fixed-income securities, real estate, infrastructure, and other investments. Their investment strategies generally reflect the expected timing and size of future pension payments, applicable regulations, funding requirements, and the risk tolerance of the fund.
Functions
The principal functions of a pension fund are to:
- collect and manage pension contributions;
- invest pension assets;
- generate returns to support future benefits;
- manage investment and financial risks;
- maintain liquidity for benefit payments;
- finance retirement benefits;
- monitor the fund's financial position relative to its obligations.
Types
Pension arrangements can generally be classified according to how retirement benefits are determined and financed.
Major types include:
- defined benefit pension plans;
- defined contribution pension plans.
Defined benefit plans
A defined benefit pension plan provides retirement benefits determined according to a specified formula.
The benefit may depend on factors such as:
- salary;
- years of service;
- age at retirement;
- a predetermined benefit formula.
The plan sponsor generally bears significant investment and funding risks because the required benefits must be financed regardless of the investment performance of the underlying assets.
Defined contribution plans
A defined contribution pension plan specifies the contributions made to an individual's retirement account rather than guaranteeing a particular retirement benefit.
The eventual retirement benefit depends largely on:
- contributions;
- investment performance;
- fees and expenses;
- the timing of withdrawals;
- the form in which benefits are received.
Investment risk is generally borne primarily by the individual participant.
Contributions
Pension funds may receive contributions from:
- employees;
- employers;
- governments;
- other participating organizations.
Contribution arrangements vary according to the pension system, plan design, employment relationship, and applicable regulations.
Investment management
Pension funds invest contributions and accumulated assets with the objective of generating returns consistent with their long-term obligations and risk constraints.
Investment activities may include:
- equity investments;
- fixed-income investments;
- real estate;
- infrastructure;
- cash and cash equivalents;
- alternative investments.
Large pension funds may manage investments internally, use external investment managers, or combine both approaches.
Asset allocation
Asset allocation is an important component of pension-fund investment management.
A pension fund may distribute assets across different asset classes to balance expected returns, liquidity requirements, and investment risk.
The appropriate allocation depends on factors such as:
- expected pension payments;
- investment horizon;
- funding position;
- risk tolerance;
- regulatory requirements;
- liquidity needs.
Diversification
Diversification can reduce concentration in individual securities, markets, sectors, or asset classes.
Pension funds may diversify investments across geographic regions, industries, currencies, and investment strategies to manage portfolio risk.
Asset-liability management
Asset-liability management is particularly relevant to pension funds because investment assets must ultimately support future benefit obligations.
ALM may consider:
- expected benefit payments;
- investment cash flows;
- interest rates;
- inflation;
- longevity;
- liquidity;
- funding requirements.
The objective is to coordinate the characteristics of the investment portfolio with the timing and uncertainty of future pension liabilities.
Liquidity management
Liquidity management ensures that sufficient resources are available to meet pension payments and other obligations when they become due.
Pension funds may maintain liquid assets or other readily accessible resources to meet expected and unexpected cash requirements.
Funding status
For a defined benefit pension plan, the relationship between pension assets and the present value of pension obligations is an important measure of the fund's financial position.
A simplified funding ratio can be expressed as:
A ratio below 100% generally indicates that the measured value of plan assets is less than the measured value of pension obligations, while a ratio above 100% indicates that assets exceed the measured obligations under the assumptions used.
Risk management
Pension funds face several types of risk, including:
- market risk;
- interest-rate risk;
- inflation risk;
- credit risk;
- liquidity risk;
- longevity risk;
- currency risk;
- operational risk.
Risk-management frameworks seek to ensure that the fund can meet its obligations while maintaining an appropriate level of investment risk.
Longevity risk
Longevity risk is the risk that pension beneficiaries live longer than anticipated, resulting in pension payments being required for a longer period.
This risk is particularly important for defined benefit pension arrangements and may affect the valuation of pension liabilities and the investment strategy of the fund.
Inflation risk
Inflation risk arises when inflation reduces the purchasing power of retirement benefits or affects the cost of future pension obligations.
Pension funds may consider investments whose returns have historically shown relationships with inflation when constructing long-term portfolios, subject to their investment mandates and risk constraints.
Governance
Pension funds are generally governed by trustees, boards, administrators, sponsors, regulators, or other responsible bodies depending on the structure of the pension system.
Governance arrangements may cover:
- investment policies;
- risk management;
- contribution requirements;
- benefit administration;
- financial reporting;
- compliance;
- fiduciary responsibilities.
Regulation
Pension funds are generally subject to legal and regulatory requirements governing matters such as:
- contributions;
- investment activities;
- disclosure;
- financial reporting;
- governance;
- participant protection;
- funding requirements.
Specific requirements vary substantially among jurisdictions.
Institutional investment
Pension funds are major institutional investors in many financial markets.
Their long investment horizons and substantial asset bases can enable them to invest in a broad range of financial and real assets.
Pension-fund investment decisions can therefore influence capital markets, corporate financing, infrastructure investment, and other areas of the economy.
Relationship with portfolio management
Portfolio management is used to construct, monitor, and adjust pension-fund investment portfolios.
Portfolio managers may use asset allocation, diversification, Portfolio rebalancing, and risk management to align investments with the fund's objectives and liabilities.
Relationship with investment strategy
Investment strategy determines how pension assets are invested in accordance with the fund's objectives, risk tolerance, liquidity requirements, and expected obligations.
A pension fund's investment strategy may combine passive and active investment approaches.
Example
Suppose a defined benefit pension fund has pension assets valued at US$900 million and the present value of its measured pension obligations is US$1 billion.
Its funding ratio is:
The fund therefore has assets equal to 90% of its measured pension obligations under the assumptions used in the calculation.
The plan sponsor and trustees may need to consider contribution levels, investment strategy, benefit obligations, and other measures when addressing the funding position.
Importance
Pension funds play an important role in retirement systems and financial markets by accumulating and investing capital over long periods to finance future retirement benefits. Their long-term investment horizon, substantial asset bases, and need to meet future obligations make asset allocation, asset-liability management, liquidity management, and risk management central to their operation.