Pension Fund Definition
Pension Fund refers to any fund, plan, or scheme that is set up by an employer (or union) which 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 the age at which a person starts receiving a monthly pension.
- Most of the pension plans offer significant tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more.
- Many pension plans offer death benefits wherein the nominee of the policy receives the defined benefit if the pensioner passes away within the policy duration.
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For eg:
Source: Pension Fund (wallstreetmojo.com)
How are Pension Funds Invested?
Historically, pension funds limited their investment to government securities, blue-chip stocksBlue-chip StocksBlue-chip stocks refer to the stock of large stable companies having market capitalization in billions that provide a good return on stocks, may provide dividends, have less risk and are considered to be safe investments. Examples of such stocks include Coca-Cola ltd, IBM Corp, Boeing Co., PepsiCo, General Electric (GE), Intel, Visa, Wal-Mart, IBM Corp, Apple, Walt Disney, Mc Donald’s, Goldman Sachs, Johnson & Johnson, etc.read more, and investment-grade bondsInvestment-grade BondsInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more. However, changing market scenario and the need to generate higher return 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 in which they usually invest.
- Fixed Income Investments: Fund managers over the years 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.
- Stocks: In most countries, these are some of the largest investors in the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more. Typically, fund managersFund ManagersFund management is the process of a company taking a person's, company's, or another fund management company's financial assets (generally high net worth individuals) and investing them in companies that use those funds as an operational investment, financial investment, or any other investment in order to grow the fund.read more focus on a combination of dividend income and growth. Some fund managers also invest in riskier small-cap stocks in search of higher growth.
- 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.
- Real Estate: It is usually don’t invest directly into real estate, but instead through passive investmentPassive InvestmentPassive investing is a strategy used by investors to maximize their returns by avoiding frequent portfolio churning by buying and selling securities and instead buying and holding a diverse range of securities.read more routes, such as private equity pools or real estate investment trusts (REITs).
- Infrastructure: They invest a tiny portion of their capital in infrastructure businesses. However, this industry has been growing with a mix of both public or private players.
Types of Pension Fund
We can broadly classify Pension Funds based on the benefits offered by the employer – defined benefit fund and defined contribution planDefined Contribution PlanA defined contribution pension plan is when the employer and the employee frequently make a significant amount of contributions to enable employees to save a decent amount of money for the retirement period and leave with the utmost dignity in their retirement phase.read more.
- Defined Benefit Plan: In these types of funds, the fund pays a fixed income to the pensioner irrespective of the performance of the fund. 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.
- Defined Contribution Plan: In these types of funds, the contribution of the employer to the fund is fixed, while the pensioner’s benefits depend on the performance of the fund. 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 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).
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 per year. ERISA doesn’t cover public pension funds, which fall under the purview of state governments or state constitution.
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 the benefits of long-term investment.
Disadvantages
- The income received from these funds after retirement is taxable.
- Most of the pension plans are best suited only for the early starters and not for all.
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