A pension plan is aretirement planthat requires an employer to make contributions to a pool of funds set aside for a worker's future benefit. The pool of funds is invested on the employee's behalf, and the capital gains and earnings on the investments are used to generate income for the worker upon retirement. The fund does not pay taxes on the capital gains it earns from investments. However, the distributions to the employee are taxed.
Pension fund assets need to be prudently managed to ensure that retirees receive promised retirement benefits. For many years, this meant that funds were limited to investingprimarily in government securities, investment-grade bonds, and blue-chip stocks.
Changing market conditions—and the need to maintain a high-enough rate of return—have resulted in pension plan rules that allow investments in most asset classes. These are some of the most common investments to which pension funds allocate their substantial capital. Here, we take a look at some of the asset classes that pension funds are likely to own.
Key Takeaways
- Pension fund assets must be managed with the intent of ensuring that eligible retirees receive the benefits they were promised.
- Until relatively recently, pensions funds invested primarily in stocks and bonds, often using a liability-matching strategy.
- Today, they increasingly invest in a variety of asset classes including private equity, real estate, infrastructure, and securities like gold that can hedge inflation.
Pension plans, also known as defined benefit plans, guarantee that employees receive a set payout regardless of how investments perform.
Fixed Income Investments
U.S. Treasury securities and investment-grade bonds are still a key part of pension fund portfolios. Investment managers seeking higher returns than what is available from conservative fixed-income instruments have expanded into high-yield bonds and well-secured commercial real estate loans. Portfolios including asset-backed securities (ABS), such as student loans and credit-card debt, are increasing. However, the risk associated with those securities tends to be quite a bit greater than typical corporate or government bonds.
As an example of the prevalence of fixed-income securities in pension portfolios, the largest pension plan in the U.S., the California Public Employees' Retirement System ("CalPERS"), seeks an annual return of 7%, with approximately one-third of its $385.1 billion portfolio was allocated to fixed-income investments as of March 2020.
Stocks
Equity investments in U.S. blue-chip common and preferred stocks are a major investment class for pension funds. Managers traditionally focus on dividends combined with growth. The search for higher returns has pushed some fund managers into riskier small-cap growth stocks and international equities.
Larger funds, such as CalPERS, self-manage their stock portfolios. Smaller funds are likely to seek outside management—or else invest in institutional versions of the same mutual funds and exchange traded funds (ETFs) as individual investors. The prime difference here is that the institutional share classes do not have front-end sales commissions, redemption, or 12b-1 fees, and they charge a lower expense ratio.
Private Equity
Institutional investors, such as pension funds, and those classified as accredited investors invest in private equity—a long-term, alternative investment category suited for sophisticated investors. In fact, pension funds are one of the largest sources of capital for the private equity industry.
In its purest form, private equity represents managed pools of money invested in the equity of privately-held companies with the intention of eventually selling the investments for substantial gains. Private-equity fund managers charge high fees based on promises of above-market returns.
$8.6 trillion
The amount of assets managed by public and private-sector pension plans in the U.S. at the end of 2018, according to the Investment Company Institute.
Real Estate
Pension fund real estate investments are typically passive investments made through real estate investment trusts (REITs) or private equity pools. Some pension funds run real estate development departments to participate directly in the acquisition, development, or management of properties.
Long-term investments are in commercial real estate, such as office buildings, industrial parks, apartments, or retail complexes. The goal is to create a portfolio of properties that combine equity appreciation with a rising stream of inflation-adjusted income to balance the ups and downs of the markets.
Infrastructure
Infrastructure investments remain a small part of most pension-plan assets, but they are a growing market of a diverse assortment of public or private developments involving power, water, roads, and energy. Public projects experience limitations due to budgets and the borrowing power of civil authorities. Private projects require large sums of money that are either expensive or difficult to raise. Pension plans can invest with a longer-term outlook and the ability to structure creative financing.
Typical financial arrangements include a base payment of interest and capital back to the fund, along with some form of revenue or equity participation. A toll road might pay a small percentage of tolls in addition to the financing payment. A power plant might pay a little bit for every megawatt generated and a percentage of the profits if another company buys the plant.
Inflation Protection
Inflation protection is a term used to refer to assets that tend to go up in value as inflation ramps up. These may include inflation-adjusted bonds (e.g. TIPS), commodities, currencies, and interest-rate derivatives. The use of inflation-adjusted bonds is often justified, but the increased allocation of pension fund assets in commodities, currencies, or derivatives has raised concerns by some due to the additional idiosyncratic risk that they carry.
Liability matching, also known as "immunization", is an investment strategy that matches future assets sales and income streams against the timing of expected future expenses. The strategy has become widely embraced amongpension fundmanagers, who attempt to minimize a portfolio'sliquidationrisk by ensuring asset sales, interest, and dividend payments correspond with expected payments to pension recipients. This stands in contrast to simpler strategies that attempt to maximize return without regard to withdrawal timing.
As an example, retirees living off the income from their portfolios generally rely on stable and continuous payments to supplement social security payments. A matching strategy would involve the strategic purchase of securities to pay outdividendsand interest at regular intervals. Ideally, a matching strategy would be in place well before retirement years commence. Apension fundwould employ a similar strategy to make sure its benefit obligations are met.
The Bottom Line
Pension funds make promises to their participants, guaranteeing them a certain level of retirement income in the future. This means they have to be relatively conservative in terms of risk, but also achieve sufficient returns to cover those guarantees. Fixed-income securities, therefore, tend to make up a big chunk of pension portfolios, along with blue-chip stocks. Increasingly, pensions have sought added return elsewhere in real estate and alternative asset classes, although these pieces still remain relatively small parts of their portfolios.
