Pension Funds: Definition, List and Issues

Top 10 Funds

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Pension funds provide money for retirement.. Photo by Stephen Chernin/Getty Images

Definition: 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.

Types

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.  Tthe 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% annually. That's their historical average. Actual returns are only 6-7%. 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 was transferred to the employee. For more on the difference, see Defined Benefit vs. Defined Contribution Plan.

Issues

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. However, 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% were in bonds and only 37% 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.

(Source: Vipal Monga and Mike Cherney, "Company Pension Plans Pile Into Bonds," WSJ, April 14, 2015)

This demand has dried up liquidity for the most popular bonds, making them harder to buy. It's one of the forces that's kept interest rates low, even after the Fed ended Quantitative Easing. It's also one of the five conditions that could lead to a bond market collapse.

Many municipalities are facing several pension shortfalls. Chicago is just the latest example. Four of its pension funds are short about $20 billion needed to pay its future retirees. That's more than 5 times Chicago's annual budget. As a result, Moody's downgraded the city's credit rating to Baa2, just above junk status.

That's increased the city's costs. Now it must offer higher interest rates on its municipal bonds to reward investors for the added risk. For more, see The Secret Threat in Municipal Bonds. (Source: Mike Cherney and Aaron Kuriloff, "Chicago Has Deep Dish of Debt Woes," WSJ, April 2, 2015) Article update May 12, 2015.

List of Top Ten Largest Pension Funds

NameWhereAssetsInvests InIssues
Social Security Trust FundU.S.$2.7 trillionU.S. Special TreasuriesFunds current Federal operations; won't meet obligations by 
Government Investment Pension FundJapan$1.26 trillion55% Japan bondsAs big as Mexico's GDP. Only earns 2.8% annually. Will switch $200 billion to stocks to earn higher return and boost Japan's stock prices.
Government Pension FundNorway$849 billionDiversifiedWorld's largest sovereign wealth fund thanks to oil revenue. 5.2% return
ABPNetherlands$425 billionDiversifiedReturned 3.9% in Q1 2014.
National Pension ServiceS. Korea$406 billionKorean assetsAssets = 1/3 of country's GDP. Must diversify out of Korea.
Federal Retirement ThriftWashington DC$326 billion Has 70% of assets needed to fund obligations. Defined Contribution plan for Federal employees.
CalPERSCalifornia$300 billion50% global stocksEarns 7.3% on investments.
Local Govt. OfficialsJapan$201 billion  
Central Provident FundSingapore$188 billionGovernment bonds 
Canada PensionCanada$184 billion  

(Source: Bloomberg, P&I Towers Watson)

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