Pension Funds: definition and general introduction

Pension funds are collective saving funds of professional character fed by companies or groups of companies or by individuals thanks to employers' and/or individual contributions.

Pension Funds economic environmentIn order to maximize the initial capital, the sums collected are managed according to the capitalization principle. They are invested in financial products in order to meet future payments of contributors' pensions.

Pension funds are institutions which are independent from the corporate entities or from the individuals who contribute to it. These pension funds are specialized in the management of pension saving. This specialisation has contributed to the mitigation of conflicts and allowed funds to optimize their performance.

This system is based on the interrelation between two or even three parties: a corporate body in private law (the pension fund), an affiliate or contracting party (a company or an individual) and possibly a managing company other than the pension fund (bank or insurance company).

We can distinguish two kinds of pension funds schemes:

  • The defined benefit pension scheme whereby the amount of payments is defined by the stakeholders in advance. The defined contribution pension scheme whereby contributions paid during active life are defined from the outset. The payments are set according to the capital set up in addition to the investment products generated by this capital. This scheme provides wider range of choices as regards to withdrawal terms and corresponds better to employees' expectations.

In the defined contribution pension scheme, the employee bears the entire risk. Contrarily, in the defined payment pension scheme, the entire financial risk is borne by the employer because the pension amount is set in advance.

The benefits granted by pension funds may be of two kinds:

  • The payment of a capital upon retirement
  • The payment of an annuity at regular intervals upon retirement

How do pension funds Work?

A retirement commitment comprises three stages:

  1. A first stage of contribution which lasts between 30 and 40 years
  2. A second stage of annuity payments which lasts about 20 years (in case of defined contributions) or the single payment of a capital upon retirement (in case of defined benefits)
  3. A third stage of a possible reversion

Used with permission from MicrosoftIn general, pension funds invest in bonds and in corporate shares that are listed on major financial markets. These two kinds of investments account for 80% of OECD pension funds' portfolios.

During contribution stage, investments target more and more liquid and safer financial assets as retirement age gets closer. This is meant to reduce volatility risks when the period of benefits payment gets closer.

During payment period, pension funds settle the annuity payments, thus providing life-time and financial guarantees. Consequently, no risk is taken and investments are, in bulk, made up mainly of bonds.

Pension Funds and the balance of retirement plans

The balance of a contributory pension scheme is obtained by means of the following equation:

The number of contributors x average contribution rate x average salary = number of retired people x average benefit

The balance of the contributory pension scheme cannot be obtained by increasing salaries because a significant distortion would emerge between the benefits provided and the salaries. The balance, therefore, depends on the contributor/number of retirees' ratio. The latter is influenced by retirement age, activity rate and age pyramid.

Since the 1960s, developed countries have witnessed a decline in fertility, the retirement of baby-boom generation, an extended life expectancy and a high unemployment rate among youth. All of these factors jeopardize contributory pension schemes. Most of the countries having adopted this system forecast a decline of benefits, especially Great Britain.

To make up for this situation, the State has thought about alternative or back-up solutions and pension funds could stand as one of the remedies to the problem.

It is, however, important to discern pension funds from other retirement saving types such as corporate saving plans, contracts underwritten with insurers or the various social welfare schemes, sovereign funds, ...

The economic role of pension funds

The giant volumes of savings managed and investment diversification policies have been particularly helpful to the development and to the internationalization of financial markets. Since the 1980s, portfolio diversification has played a key role in the movement of capital and outflow. It has allowed to reach a better long-term performance while reducing risk.

Moreover, their liabilities being spread out over along period of time, the pension funds are not submitted to considerable liquidity risks. In normal times, they are not subject to massive assets withdrawals.

Taking full advantage of their formidable weight on financial markets, they have managed to adopt two apparently opposite policies to enhance drained capitals.

  • Short-term investment. Security holding being provisional, pension funds do not interfere with corporate management.
  • Long-term investment. Pension funds are then generally positioned as minority shareholders in order to optimize benefit from dividends over a long period of time.

Pension FundsIn the second case, active management of portfolios is designed to maximize their return on investment. They are, therefore, keen on the quality of corporate management where they hold stakes.

By investing in listed companies, the pension funds keep withhold the possibility of impacting corporate decisions directly or indirectly: use of voting rights, influence over management, resort to press and media, ... The purpose behind this is to bring transparency in financial management and in information flow. They also control dividend payments. Moreover, numerous leaders of large international firms stepped down under pressure exerted by pension funds (IBM, Kodak, General Motors, American Express, ...).

It is worth noting that pension funds alter the funding of the economy while impacting the financial markets. In the countries where companies traditionally get funded through loans, the masses invested in the stock market by pension funds enable companies to get funded through the growing issue of shares. They, therefore, have less recourse to loans. This leads to an increase of stock market listing and of private bond issuance.

Pension Funds: Brief historical background

In France, it is the (1792-1795) National Convention which gave birth to the idea of retirement plans. In Germany, the first retirement scheme plan was born in 1889 with employers' participations up to 50% into the saving plan. The beneficiary had to contribute for a minimum period of 30 years and fulfil an age requirement of 60 years to be eligible for a pension.

As of 1946, in accordance with the principle of universal social welfare, we have witnessed a multiplication of the retirement schemes in economically-advanced countries.

As of the 1950s, pension funds have developed quickly in the United States thanks to the adoption of fiscally-advantageous provisions for employers.

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