A pension fund is a pool of assets established by a public- or private- sector employer to provide retirement income for employees. These assets must be prudently managed to ensure that retirees receive their promised benefits. For many years, this meant that funds primarily invested in government securities, investment-grade bonds, and blue-chip stocks.
Due to evolving market conditions, as well as the need to maintain a sufficiently high rate of return, pension plan rules have now changed to allow investments in most asset classes. This article examines both the traditional and newer assets that are included in today’s pension fund portfolios.
Key Takeaways
- Pension fund assets must be managed with the intent of ensuring that eligible retirees receive the benefits they were promised.
- In the 2020s, pension funds started to diversify and include asset classes beyond traditional stocks and bonds. Fixed-income and blue-chip stocks remain crucial, however.
- Additional asset classes in pension funds include private equity, real estate, infrastructure, and securities like gold that can hedge against inflation.
- Infrastructure and real estate make up smaller, strategically important sections of pension fund portfolios.
Fixed Income Investments
U.S. Treasury securities and investment-grade bonds are still a key part of pension fund portfolios. Investment managers who seek higher returns than what’s 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 as well. The risk associated with those securities tends to be quite a bit greater than typical corporate or government bonds, however.
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 the California Public Employees’ Retirement System (CalPERS) self-manage their stock portfolios. Smaller funds are likely to seek outside management or invest in institutional versions of the same mutual funds and exchange-traded funds (ETFs) as individual investors. The primary difference here is that the institutional share classes don’t have front-end sales commissions, redemption, or 12b-1 fees. They charge a lower expense ratio as well.
Private Equity
Institutional investors such as pension funds and those classified as accredited invest in private equity: a long-term alternative investment category suited for sophisticated investors. Pension funds are one of the largest sources of capital for the private equity industry.
Private equity represents managed pools of money invested in the equity of privately held companies to eventually sell the investments for substantial gains. Private equity fund managers charge high fees based on promises of above-market returns.
Important
Public and private-sector pension plans in the U.S. managed $40 trillion in assets in the second quarter of 2024, 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’re a growing market of a diverse assortment of public and private developments that involve power, water, roads, and energy. Public projects experience limitations due to budgets and the borrowing power of civil authorities. They 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 for every megawatt generated and a percentage of the profits if another company buys the plant.
Inflation Protection
Inflation protection is a term that’s used to refer to assets that tend to go up in value as inflation ramps up. They can include inflation-adjusted bonds (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 they carry.
What Is a Pension Plan?
A pension plan is a retirement plan that requires an employer to make contributions to a pool of funds set aside for a worker’s future benefit. The pool 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 doesn’t pay taxes on the capital gains it earns from investments but distributions to the employee are taxed.
What Is Liability Matching?
Liability matching, also known as “immunization“, is an investment strategy that matches future asset sales and income streams against the timing of expected future expenses. The strategy has become widely embraced among pension fund managers who attempt to minimize a portfolio’s liquidation risk by ensuring that 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.
Retirees living off the income from their portfolios generally rely on stable and continuous payments to supplement their Social Security income. A matching strategy would involve the strategic purchase of securities to pay out dividends and interest at regular intervals. A matching strategy would ideally be in place well before retirement years begin. A pension fund would employ a similar strategy to ensure that its benefit obligations are met.
What Is a Defined Benefit Plan?
Pension plans are also known as defined benefit plans. They guarantee that employees receive a set payout regardless of how investments perform.
The Bottom Line
Pension funds make promises to their participants, guaranteeing them a certain level of retirement income in the future. 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. Pensions have increasingly sought added returns elsewhere in real estate and alternative asset classes but these pieces remain relatively small parts of their portfolios.