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Pension Fund

Updated on March 19, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Pension Fund Definition

Pension Fund refers to any fund, plan, or scheme set up by an employer (or union) that generates regular income for employees after their retirement. This pooled contribution from the pension plan is usually invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.

Features

  • Pension Fund provides a steady flow of income to the employees after retirement.
  • In most plans minimum vesting age lies in the range of 40 to 50 years, while the maximum age goes up to 70 years. Vesting age is when a person starts receiving a monthly pension.
  • Most pension plans offer significant tax benefits.
  • Many pension plans offer death benefits wherein the policy nominee receives the defined benefit if the pensioner passes away within the policy duration.
Pension Fund

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How are Pension Funds Invested?

Historically, pension funds limited their investment to government securities, blue-chip stocks, and investment-grade bonds. However, changing market scenarios and the need to generate higher returns has forced pension plans to amend the rules to allow investments in almost all asset classes. Now, let us look at some of the asset classes they usually invest in.

  1. Fixed Income Investments: Fund managers have expanded their horizons to include high-yield bonds and secured commercial real estate loans to generate higher returns than the conservative fixed income investment over the years.
  2. Stocks: In most countries, these are some of the largest investors in the stock market. Typically, fund managers focus on a combination of dividend income and growth. Some fund managers also invest in riskier small-cap stocks for higher growth.
  3. Private Equity: It serves the purpose of a long-term alternative investment strategy suited for mature investors. A large portion of the funding for the private equity industry comes from pension funds.
  4. Real Estate usually doesn’t invest directly into real estate but through passive investment routes, such as private equity pools or real estate investment trusts (REITs).
  5. Infrastructure: They invest a tiny portion of their capital in infrastructure businesses. However, this industry has been growing with a mix of public and private players.

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Types of Pension Fund

We can broadly classify Pension Funds based on the benefits offered by the employer – defined benefit fund and defined contribution plan.

#1 – Defined Benefit Plan

In these types of funds, the fund pays a fixed income to the pensioner irrespective of the fund’s performance. In these funds, the fund manager has to ensure that the fund generates enough return to cover the retirement benefits of the pensioner. In case of any shortfall, the employer must pay the difference. On the other hand, if the fund generates a higher return, then the employers enjoy the benefit. Effectively, the employer bears all the risks in the defined benefit fund.

#2 – Defined Contribution Plan

In these types of funds, the employer’s contribution to the fund is fixed, while the pensioner’s benefits depend on the fund’s performance. So, the employer is not liable to pay out the difference in case the value of the fund drops. Effectively, all the risk transfers to the pensioner.

List of Top 10 Largest Public Pension Funds

Below is the list of the top 10 largest public pension funds from across the globe, sorted according to the asset under management (AuM).

top 10 largest public pension funds

Source: Globe Newswire

Regulations of Pension Fund

In the US, private pension plans are regulated by the Employee Retirement Income Security Act (ERISA) of 1974. It defines the minimum standards to be followed while managing a pension plan to safeguard the interest of the participants. It also guarantees employee retirement benefits, under Pension Benefit Guaranty Corporation (PBGC), in case the employer goes out of business. Under PBGC, a 65-year-old retiree is eligible for a maximum guaranteed amount of $69,750 annually. ERISA doesn’t cover public pension funds, which fall under the purview of state governments or state constitutions.

Benefits

  • Most pension funds offer the flexibility to choose the asset class in which they want to invest – only debt, only equity, or a mix of both.
  • The investment grows tax-free in most of these funds.
  • Since these are invested in long-term assets, the beneficiaries can enjoy long-term investment benefits.

Disadvantages

  • The income received from these funds after retirement is taxable.
  • Most pension plans are best suited only for the early starters and not all.

This article has been a guide to What is the Pension Fund & its definition. Here we discuss how it works along with features, investments, regulations, benefits, and disadvantages. You can learn more about it from the following articles –