What is a Pension Fund?
A pension fund is a fund that accumulates capital to be paid out as a pension for employees when they retire at the end of their careers.
Pension funds typically aggregate large sums of money to be invested into the capital markets, such as stock and bond markets, to generate profit (returns).
A pension fund represents an institutional investor and invests large pools of money into private and public companies. Pension funds are typically managed by companies (employers). The main goal of a pension fund is to ensure there will be enough money to cover the pensions of employees after their retirement in the future.
- A pension fund is a pool of money that is to be paid out as a pension when employees retire.
- Pension funds invest that money to multiply it, which will potentially provide more benefit to the retirees.
- Pension payout amounts are dependent on the percentage of the average salary of an employee for the last few years of their employment.
What is a Pension Plan?
A pension plan is defined as a retirement plan where both employers and employees contribute capital into a pool of funds put aside for future pension payments. The funds are invested on behalf of the employees instead of just sitting idly in bank accounts. The returns generated from the investments serve as earnings to the employee upon retirement.
How Do Pension Funds Work?
Most commonly, pension plans are defined benefit plans, which means that employees will receive pension payments equal to a certain percentage of their average salary paid throughout their last few years of employment.
Open vs. Closed Pension Funds
Open pension funds are custodians of at least one pension plan with no membership restriction. Closed pension funds support pension plans that are only open to specific employees.
Closed pension funds can be further classified into:
- Single-employer pension funds
- Multi-employer pension funds
- Related member pension funds
- Individual pension funds
Where Do Pension Funds Invest?
The main investment style of a pension fund is diversification and prudence. Pension funds aim for portfolio diversification, allocating capital to different investment instruments (stocks, bonds, derivatives, alternative investments, etc.).
However, for many years, pension funds were limited to investments primarily in government-backed securities, such as bonds with a high credit rating (investment-grade bonds) and blue-chip stocks. Since markets evolve and given a constant need for a relatively high rate of return, pension funds have been allowed to invest in the majority of asset classes.
Nowadays, many pension funds have transferred from active stock portfolio management to passive investment instruments, investing in index funds and in exchange-traded funds that track stock indexes. Emerging trends are to allocate capital to alternative investments, specifically to commodities, high-yield bonds, hedge funds, and real estate.
Portfolios of asset-backed securities, e.g., student loans or credit card debt, are new tools used by pension funds to increase the overall rate of return. Private equity investments are becoming more and more popular among pension funds. They are simply long-term investments into privately-held companies. The goal of private equity investments is to cash out (sell a business) when the business matures for significant gains.
Real estate investment trusts (REITs) are also quite popular among pension funds, being passive investments in real estate markets. Commercial real estate investments are also made in building offices, warehouses, industrial parks, etc.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst.
Through financial modeling courses, training, and exercises, anyone in the world can become a great analyst. To keep advancing your career, the additional CFI resources below will be useful: