Pension Fund Investments

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:

• 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.

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