A pension fund is a financial pool that gathers funds with the intention of providing pension payments to contributors when they retire at the end of their careers.
Given the critical role of a pension — and the fact that they can go wrong — it's important to know how these funds operate, including how they make enough money to remain sustainable.
By the end of this article, you'll have a better understanding of the strategies used by pension funds to help individuals enjoy a comfortable retirement.
What do pension funds do?
Pension funds serve as special accounts for collecting money from different sources like employers, unions, or organizations. This money is specifically set aside to provide retirement benefits to employees or members. A pension fund's main purpose is to ensure that people receive a steady income once they retire, allowing them to live comfortably and enjoy their post-work life.
Pension funds often receive special tax benefits that help them grow and generate retirement income more effectively. Usually, they don't have to pay taxes on their profits from investments, which allows the funds to grow faster.
Additionally, the money earned within the fund may not be subject to taxes right away or even be completely tax-free, depending on the rules in place where the fund operates.
A pension fund is distinct from other investment funds, such as sovereign wealth funds, ETFs, index funds, mutual funds, and REITs.
Types of pension funds
- Public sector funds. These funds cater to public sector workers, such as government employees and teachers, who participate in pension plans sponsored by provincial, state, or national governments. Public sector pension funds are designed to provide retirement benefits for public employees and are often managed by government entities or specialized pension boards.
- Private sector funds. Private sector pension funds are established and managed by independent organizations authorized to oversee the pension plans of different employers. These funds cover workers employed in various private sector industries, including businesses, corporations, and non-governmental organizations. Private sector funds provide retirement benefits based on the specific provisions outlined in each employer's pension plan.
- Corporate funds. Corporate pension funds are dedicated to serving employees enrolled in company-sponsored pension plans. The employing organization directly manages these funds and aims to secure retirement benefits for their workers. Corporate pension funds are typically customized to align with the company's and its employees' specific needs and goals.
In all types of pension funds, professional fund managers are responsible for overseeing the investment portfolios and making strategic decisions to maximize returns while managing risk. These managers carefully allocate funds across a diversified range of investments, such as stocks, bonds, real estate, and other financial instruments, to achieve long-term growth and ensure the sustainability of the pension fund.
How do pension funds make money?
Pension funds generate money through regular contributions made by employers and sometimes employees, typically on a monthly basis. This accumulated capital is then invested in various financial markets, such as stocks and bonds, with the goal of earning a profit. These investments are managed by professional pension fund managers who have expertise in making sound investment decisions.
The responsibility for investment decisions lies with the employer or the pension fund manager, depending on the specific arrangement. Employees generally have limited control over the investment choices or the allocation of funds within the pension fund. This is because investment decisions are made by professionals who aim to maximize returns and ensure the fund's long-term sustainability.
Pension funds pool significant amounts of money to be invested in capital markets. By investing in stocks, bonds, and other financial instruments, pension funds seek to generate profits, also known as returns. These returns are crucial in sustaining the pension fund by covering administrative costs, such as salaries and operational expenses, and providing funds to pay retirees their pension benefits.
When individuals reach retirement age, pension funds typically offer different payout options. Some pension funds may provide a lump sum payment equal to one-third of the total funds accumulated. The remaining two-thirds are then used to pay the pensioner a regular income stream, known as a living annuity, throughout their retirement years. This approach allows retirees to access a portion of their savings upfront while ensuring a steady income to support their post-employment lifestyle.
Risks
While pension funds are crucial in providing retirement benefits, they are not immune to risks and challenges. Here are some notable risks associated with pension funds.
- Market volatility. Pension funds are exposed to fluctuations in stock markets, which can result in significant losses. For instance, during the period from 2000 to 2002, defined benefit plans in the United States experienced a loss of approximately $400 billion in funding levels, as reported by Franzoni and Marin (2006). Turbulent stock markets can erode the value of investments held by pension funds and impact their overall financial health.
- Economic downturns. Economic downturns, such as the global financial crisis in 2008, can have a detrimental effect on the funding ratios of pension funds. Factors like poor stock market performance and declining interest rates can significantly impact the financial standing of pension funds. In 2008, many pension funds faced challenges in maintaining adequate funding levels due to these adverse economic conditions.
- Legislative and regulatory factors. Legislative changes can have unintended consequences for pension funds. The Employee Retirement Income Security Act of 1974, for instance, aimed to protect pension funds by setting guidelines and standards. However, it unintentionally led some companies to discontinue offering pension plans altogether. Regulatory changes or unexpected policy shifts can create challenges and uncertainties for pension funds.
- Impact of global events. Global events, such as the COVID-19 pandemic, can have a profound impact on pension funds. The pandemic-induced market volatility resulted in declining share prices, and the recovery process for stock markets, including the S&P 500, has been ongoing. This presents a challenge for pension funds that rely on their investment returns to fund retirement benefits. The lower investment returns can strain the ability of pension funds to meet their obligations to retirees.
