Pension Funds: Types, Top 10, Issues
Are They a Ticking Time Bomb?
Pension funds are corporate investment pools that pay for employee retirement commitments. Employees and employers contribute into the fund. The managers invest these contributions conservatively so as not to lose the principal but still beat inflation.
There are two types of pension funds. The first is the Defined Benefit fund. It's obligated to pay a fixed income to the beneficiary, regardless of how well the fund does.
The employee pays a fixed amount into the fund. The fund manager must receive enough of a return on the investment to pay for the benefits. The corporation must pay for any shortfall.
Companies assume the funds will return 7-8 percent annually. That's their historical average. Actual returns are only 6-7 percent. That means companies aren't contributing enough for future payouts. (Source: "Many Unhappy Returns," The Economist , September 12, 2015.)
The Defined Benefit pension fund is what most people think of when they say "pensions" because you receive the same amount pretty much guaranteed. This is like an annuity provided by an insurance company. In this case, the employer functions as the insurance company and sustains all the risk if the market drops. Benefits are guaranteed by the federal government by the Pension Benefit Guaranty Corporation.
The second type is a Defined Contribution fund.
The beneficiary's benefits depend on how well the fund does. The most common of these are 401 (k)s. The employer doesn't have to pay out defined benefits if the fund drops in value. The risk is transferred to the employee. The shift in risk is the most important difference between the defined benefit and the defined contribution plan.
In the 1980s, corporations found that it was more advantageous for them to switch to defined contribution plans. As a result, fewer and fewer employees are covered by pensions. Government plans, including Social Security, stayed with defined benefit plans. But the payouts aren't enough to cover a decent standard of living.
Pension funds were decimated by the 2008 financial crisis. Since then, many managers increased their holding of bonds to lower risk. By 2014, many of the largest funds held a greater percentage of fixed income than they did of stocks and other riskier assets. That year, the 50 largest defined benefit plans in the S&P 500 held $947.7 billion in total assets. Of that, 41 percent were in bonds and only 37 percent were in stocks.
In most demand are long-term bonds, including 10-year Treasury note. That's because managers want to redeem the bonds when the bulk of their employees retire in 10, 20 and 30 years. As a result, companies sold $604.9 billion of high-grade bonds with maturities of 10 years or more, double the annual average sold since 1995. Pension funds account for nearly half of all new 40-year and 50-year corporate bonds bought.
This demand has dried up liquidity for the most popular bonds, making them harder to buy.
Many municipalities are facing several pension shortfalls. For example, four of Chicago's pension funds are short about $20 billion needed to pay its future retirees. That's more than five times Chicago's annual budget. As a result, Moody's downgraded the city's credit rating to Baa2, just above junk status.
List of Top 10 Largest Pension Funds
|Social Security Trust Fund||U.S.||$2.7 trillion||U.S. Special Treasuries||Funds current federal operations.|
|Government Investment Pension Fund||Japan||$1.26 trillion||55% Japan bonds||2.8% return. Will switch $200 billion to stocks.|
|Government Pension Fund||Norway||$849 billion||Diversified||World's largest sovereign wealth fund. 5.2% return|
|ABP||Netherlands||$425 billion||Diversified||3.9% return in Q1 2014.|
|National Pension Service||S. Korea||$406 billion||Korean assets||Assets are 1/3 of country's GDP. Must diversify.|
|Federal Retirement Thrift||Washington DC||$326 billion||Has 70% of assets needed to fund obligations.|
|CalPERS||California||$300 billion||50% global stocks||7.3% return.|
|Local Govt. Officials||Japan||$201 billion|
|Central Provident Fund||Singapore||$188 billion||Government bonds|
|Canada Pension||Canada||$184 billion|