The value of U.S. pension funds at the end of 2015 was $21.7 trillion. The funds' managers prudently manage assets in a method meant to ensure that retirees receive promised benefits. For many years this meant that funds were limited to investing primarily in government securities, investment-grade bonds, and a small amount placed in blue-chip stocks. Changing market conditions and the need to maintain a high rate of return have resulted in pension plan rules that allow investments in most asset classes.
U.S. Treasury securities and investment-grade bonds are still part of pension fund portfolios. Investment managers searching for higher returns than available from conservative fixed-income instruments are expanding into high-yield bonds and well-secured commercial real estate loans. Portfolios of asset-backed securities, such as student loans and credit-card debt, are new tools intended to bump overall return.
The United States' largest pension plan, the California Public Employees' Retirement System (CalPERS), seeks an annual return of 7.5%. As of June 30, 2016, income investments comprised 20.3% of its portfolio.
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 return has pushed some fund managers into riskier small-cap growth stocks and international equities.
Larger funds such as CalPERS self-manage portfolios. Smaller funds invest in institutional versions of the same mutual funds and exchange-traded funds (ETFs) as individual investors. The only difference is that the institutional share classes do not have front-end sales commissions, redemption charges or 12b-1 fees and charge a lower expense ratio.
In its purest form, private equity represents managed pools of money invested in the equity of privately held companies with the intention of eventually selling the investments for substantial gains. Private-equity fund managers charge large fees based on promises of above-market returns. Private equity is also a catchall term for many different types of hedge fund and alternative investments. Pension funds are one of the largest sources of capital for the private equity industry.
Pension fund real estate investments are passive investments made through real estate investment trusts (REIT) or private equity pools. Some pension funds run real estate development departments to participate directly in the acquisition, development or management of properties. The 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 out the ups and downs of the security markets.
Infrastructure investments are a small part of most pension plan assets, but they are a potentially growing market. A diverse assortment of public or private developments involving power, water, roads and energy. Public projects experience limitations due to budgetary limits and the borrowing power of civil authorities. Private projects 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 bit for every megawatt generated and a percentage of the profits if another company buys the plant.
Inflation protection is a benign term that is used to cover everything from inflation-adjusted bonds to commodities, currencies and derivatives. The inflation-adjusted bonds make sense, but the prudence of investing pension funds' assets in commodities, currencies or derivatives is questionable. A current trend from asset management companies is the offering of mutual funds that engage in these types of risky alternative investments.