Pension funds: definition, function and types of proposed contracts

Pension funds, definition

Pension funds are collective investment undertakings (UCITs) that manage employee savings and retirement. Their primary objective is to provide pensioners who have reached retirement age with income in the form of a lifetime pension or capital. Unlike public pension funds managed on a pay-as-you-go basis, pension funds are managed by capitalization.

When members reach retirement age, they are provided with either an annuity or a capital paid by the fund.

At the core of pension fund operations are three types of activity: premium collection, investment of sums collected, benefits paid.

Difference between public pension funds and private pension funds

In a public pension fund referred to as a pay-as-you-go pension plan, contributions paid by the assets are designed to pay pensions for retirees. This system, which is generally compulsory, rests on inter-generational solidarity. Being very vulnerable to unemployment and demographic changes, the financial balance of the system depends on the ratio of the number of contributors to that of the pensioners.

Unlike this system, private pension funds or fully-funded pension plan is often individual and voluntary, allowing working people to set up their own retirement. They save during their working lives to insure their old age. The contributions received are the subject of financial investments. The return on these investments depends primarily on market developments.

Pension funds, different types of plans

Pension funds can offer two types of contract: the defined benefit contract and the defined contribution contract.

Defined benefit pension plan

As conveyed by its name, this plan defines the benefits that will be paid to the future pensioner as soon as the contract is signed. These benefits are therefore guaranteed, regardless of investment returns and market conditions.

The amount of the contributions is not defined when the contract is concluded. It varies according to market conditions and interest rate fluctuations.

This pension plan is generally made available only to employees. Companies undertake to offer it to their employees, bearing the risk of an increase in contributions.

Defined contribution (DC) plans

Unlike defined benefit plans, people who have signed a defined contribution contract, whether they are wage earners or self-employed, do not know the amount of benefits they will receive on retirement. Benefits depend on market conditions and investment returns. On the other hand, the amount of contributions is known in advance. With this kind of contract, the risk of investment is borne by the contractor.