Pension funds are a large pool of savings that hold the financial contributions of many participants: primarily employers and employees.
Such funds are invested to benefit the workers towards a financially secured retirement.
Pension funds are invested and managed by professionals under strict oversight by regulatory authorities.
The pension fund administrators serve as investors, putting the money into assets that yield profits for the employees when they retire.
What is a Pension Fund?
A pension fund is an accumulation of different kinds of savings made during an employee’s service years. They include contributions of employers and employees, investments and other types of benefits.
It is a retirement plan strictly regulated by authorities, pulling funds from different sources, including employer contributions. These funds are channeled into different kinds of investments that accrue to the worker on retirement.
The idea behind pension funds is to ensure that employees have the best rate of return. Pension funds ensure that most of the contributions are invested on assets to yield as much profit as possible.
How Does It Work?
Pension funds are required to ensure that the interests of their clients are put ahead of theirs in funds management and investment. They redirect funds into profitable ventures, which create benefits for their clients.
When pension funds receive money from the contributors (employers and employees), they go to work with it with a guarantee that the employer would have profitable returns when they retire.
Pension funds invest the money on a long-term basis seeking the most viable pathway for the best rate of return.
Pension funds invest in properties directly, provide mortgage capital and partner with real estate firms to provide funds for profit.
How Do Pension Funds Invest Money?
Pension funds invest smartly to guarantee returns. Since they have a large pool of contributions, they can provide much-needed funding for critical sectors that guarantees returns at different levels of security.
Although strict regulations guide investments, pension funds have a wide array of investment options to choose from for the benefit of their clients. There are many ways pension funds invest money. Let’s look at them in detail.
Fixed income investments
One way by which pension funds invest money is by fixed income. Fixed income is an investment approach that offers a steady stream of income with less risk than stocks. It focuses on investments like government and corporate bonds and intends to preserve capital and income.
In a broader sense, fixed income is an investment that pays a fixed dividend for some time until it matures. When the investment reaches the date, the amount invested is repaid in full.
This type of investment is very secure and is offered mainly by giant corporate firms and government agencies. When they require funds for substantial capital projects, these kinds of securities are issued.
The greatest advantage is that apart from offering a guarantee of the capital upon maturity- a fixed period -, there is a regular cash flow that goes to the investor. Also, the periodic payment is not subject to irregular changes, and the rates are always known to the investor ahead of time.
If, for example, a government agency issues a 6% bond for every $10,000 for a period of 10 years, what it means is that if a pension fund invests in it, they won’t get back the funds for ten years. However, every year, they’ll get a payment of $600 based on the bond; and would receive the initial capital of $10,000 after maturity of the bond.
Fixed income investments are secured. If a pension fund invests in a giant firm that eventually collapses, fixed income investors still have a level of guarantee of getting back their funds. The funds are secured against bankruptcy and sudden losses. Fixed-income investors are settled before other investors in such cases.
There are different types of fixed-income investments. The most common include Treasury bills, which run for a year without any periodic payments; Treasury notes, which can run for up to ten years; and Treasury bonds, which run for up to two or more three decades.
The greatest advantage of this type of investment is the steady, secure income stream, and backing by the government.
However, mainly because of its security, it doesn’t offer huge returns, unlike other investments.
Private equity firms raise money from investors like pension funds and invest them in different types of assets.
Private equity is a composition of investors who directly invest in private entities. They may also completely buy out a public corporation, making it “private” and out of the public domain. One of the largest investors in private equity is pension funds.
By investing in private equity, investors provide funds for the expansion and running of such companies. The investors offer as much as 99% of the funds with limited liability, while general partners supply the remaining 1% with total liability.
Private equity investment provides the window of long-term investments for companies that need an urgent injection of funds. It offers a more direct source of funds for such entrepreneurs who need urgent capital. Some private equities also finance new companies and startups.
The major types of private equity financing include distressed funding, leveraged buyouts and venture capital.
Because private equity firms help inject much-needed funds into investments that ultimately yield lots of profit, it is a viable investment platform for investors who have lots of money for the long term.
The greatest advantage is that the funds are well managed by firms and yield profit for investors. On the other hand, the greatest disadvantage of private equity is that though profitable, there are limited opportunities in the field.
One other sector that pension funds invest in is infrastructure, although it still represents a small part of its investment assets.
In most developing countries, pension funds remain a viable funding source for significant infrastructure projects like power, roads, housing, water and bridges. Both public and private projects suffer huge limitations in funding infrastructure projects which can be funded by pension funds..
Infrastructure projects are often long-term and require funding that can back them up for long periods. Most such projects like power and roads are viable and can pay back the loans over a period. Roads, for example, could be tolled to augment repayment funds. In a typical sense, the financial arrangements involve a base payment of interest and capital back to the fund, backed up with a form of recurrent revenue.
Reports have shown that pension funds would profit more if they increase their activity in the infrastructure sector, especially in developing countries, as it offers a win-win situation for everyone involved. The only problem is the strict financial regulations that are preventing such active participation.
Similarly, pension funds can invest in real estate albeit passively. But some pension funds invest actively in the real estate industry by financing commercial buildings that are economically viable.
Inflation protection is used to describe assets that increase in value when inflation bites harder. Pension fund administrators have increasingly used this mode of investment called Liability matching.
What it does is to match impending asset sales and income against the timing of expenses. By so doing, pension funds minimize the risk of losses and liquidation by timing asset sales to correspond with pension payments.
Thus, pension funds invest to ensure that payments to clients coincide with periods of interest on securities.
Pension funds invest in stocks and rely on high dividends with the hope that the firm grows. While stocks can offer huge returns, they could be very risky as they are usually unstable.
Pension funds act as investors by channelling their clients’ contributions into ventures that yield profit.
Several long-term investment opportunities are available which can help pension funds maximize profit for the benefit of their clients. Although many are pretty risky, several options offer safe, guaranteed returns to the advantage of retirees.
John E Chambers is an experienced financial advice expert. Born in Chicago, he has a master's in Industrial Finance, but he has spent decades offering investment advice to businesses and individuals alike. He is the founder of RetireeWorkforce.com and wants the website to be valuable for retirement advice. In addition, he writes articles that help users jump-start their retirement plans and choose the best investment options. If not pondering over stock market statistics or reading some magazines, you can find John spending time with his family. As an early retiree, John also offers unique insights into what post-retirement life is like.