Pension funds can invest in many different types of financial
securities and can own assets directly. The type of investments undertaken
by a pension fund depend on its "investment policy statement". The
nature of the investments allowed in the policy statement depend in a large
part on the financial situation of the plan. Generally, the better the
finances and the younger the plan participants, the more riskier the
investments that can be held by the plan.
Without debating the finer points of pension plan law, we can say that
pension plans exist to provide post-retirement income to employees. A
pension plan is really a number of promises to pay people income after
retirement. In a traditional "defined benefit" pension plan, the
pensions are defined according to a formula specified in the plan
documents. This usually takes the form of a percentage of the "best
years" of salary.
At any point in time, an actuary can calculate how much money must be
set aside to cover the future cost of pensions, given an investment return
until eventual retirement. Actuaries also calculate how much a company
must contribute to its pension plan to cover its obligations. Accountants
also get into the act, providing a valuation of a company's "vested
benefit obligation" which are pension obligations given an immediate
termination of the pension plan.
Investment Policy
Many years ago, a company might make a promise to pay pensions without
setting aside any funds to support this promise. As these arrangements
became more formal, government regulations were established to ensure the
promised pensions were available and required that companies put aside the
necessary funds to ensure that pensions were paid. Once companies were
required to set aside monies to fund their pension promises, it became
attractive to invest these funds to earn a higher return that would lower
the cost of providing pensions.
It is not so long ago that companies would put their pension funds in
government bonds or life insurance company annuities. As inflation rose in
the 1960s and 1970s, companies found that rising salaries and low
fixed-income returns made their pension plans very expensive. They turned
increasingly to investment in equities to obtain a higher return and lower
the eventual cost of their pension plans. More sophisticated plans began
to place funds in direct real estate investment, venture capital and
mortgages. By the 1980s, pension plans were exploiting "non-traditional"
investments in Leverage Buyout Funds (LBOs), hedge funds and even direct
ownership of private companies
Pension plans are usually considered "patient capital" because
of their long time horizon. The type of investments undertaken by a
pension fund depend on its objectives and constraints which are provided
for in its "investment policy statement". Legislation demands a "prudent
approach" of diversifying risk across a number of securities or asset
types. Taking prudence into account, pension funds strive to achieve the
highest practical return which lowers the cost of their pension "obligation"
considerably.
A Plan's Financial Condition Matters
The major limiting factor to putting all of a company's pension fund in
very high return and "risky" assets is the financial condition
of the pension fund. A pension fund that doesn't have enough invested to
cover its pension obligations is said to be "underfunded" or
have a "shortfall" in invested assets and companies are required
to make this up through higher contributions. A pension fund that has more
investments than necessary to cover its pension obligation is "overfunded"
or said to have a pension "surplus". Companies with a pension
surplus can reduce or suspend their contributions altogether.
The financial condition of a pension plan depends on a number of
factors, including:
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The demographic characteristics of the plan members very much
dictates the time horizon for investment. If the plan sponsor is a new
company with relatively young employees, the eventual pensions are very
far in the future. This means if the value of the plan investments
fluctuate considerably, there will not be a need for funds to be
withdrawn at a low point when the investments' value is down
considerably. A "young plan" can have a high weighting in
riskier or more illiquid assets such as stocks, real estate and
non-traditional investments.This is in contrast to a "mature plan"
which has much older participants and actually is paying pensions to
many retirees. The investments of these plans usually are much more
towards fixed income securities such as bonds and mortgages which
fluctuate much less in price and provide a stable income source to pay
pensions regularly.
-
The financial state of the company itself is important. If a
company is in a difficult financial situation, it will be more difficult
to make large contributions to the pension fund to make up potential
shortfalls from investment performance. This usually results in a more
capital risk averse approach and higher fixed income weighting.
-
The historical investment performance of the fund's
investments results in the amount of assets available at any point. A
plan with poor historical investment performance will have generated a
much lower rate of return and therefore will have less funds on hand to
provide for pension obligations. Perversely, a "conservative"
investment approach with a low equity weighting will result in low
returns which might lower the future risk tolerance of a plan.
As opposed to people, patience is the characteristic of "young"
and well-financed pension plans. With pension plans, "maturity"
and shortfalls brings impatience and shorter time horizons as the certain
pension payouts move closer with each passing year. |
