Pension fund assets need to be prudently managed to ensure that retirees receive promised retirement benefits. For many years this meant that funds were limited to investing primarily in government securities, investment-grade bonds, and blue-chip stocks.
Changing market conditions—and the need to maintain a high-enough rate of return—have resulted in pension plan rules that allow investments in most asset classes. These are some of the most common investments to which pension funds allocate their substantial capital.
- Pension fund assets are managed with the intent to ensure that retirees receive the benefits they were promised.
- Until relatively recently, pensions funds invested primarily in stocks and bonds.
- Today, they invest in a variety of asset classes including private equity, real estate, infrastructure, and securities that hedge inflation.
U.S. Treasury securities and investment-grade bonds are still part of pension fund portfolios. Investment managers seeking higher returns than available from conservative fixed-income instruments have expanded 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 newer tools intended to boost overall returns.
The largest pension plan in the U.S., the California Public Employees' Retirement System (CalPERS), seeks an annual return of 7.5%. Approximately 23% of its $365 billion portfolio was allocated to income investments as of June 2019.
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 returns has pushed some fund managers into riskier small-cap growth stocks and international equities.
Pension plans, also known as defined benefit plans, guarantee that employees receive a set payout regardless of how investments perform.
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 or 12b-1 fees, and charge a lower expense ratio.
Institutional investors, such as pension funds, and those classified as accredited investors invest in private equity—a long-term, alternative investment category suited for sophisticated investors. In fact, pension funds are one of the largest sources of capital for the private equity industry.
The amount of assets managed by public and private-sector pension plans in the U.S. at the end of 2018, according to the Investment Company Institute.
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 high fees based on promises of above-market returns.
Pension fund real estate investments are passive investments made through real estate investment trusts (REITs) or private equity pools. Some pension funds run real estate development departments to participate directly in the acquisition, development, or management of properties.
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 the ups and downs of the markets.
Infrastructure investments are a small part of most pension-plan assets, but they are a growing market of a diverse assortment of public or private developments involving power, water, roads, and energy. Public projects experience limitations due to budgets 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 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 due to the risk they carry.
A current trend from asset management companies is offering mutual funds that engage in these types of risky alternative investments.