Pension funds

Katie Morley of the Financial Times's Pensions Week explains how they work and why they're so important in the finance world
Other finance
Private equity

Pension funds are the investment vehicles that provide us with a retirement income. These funds need to invest money in assets that will provide a certain level of return over a long period of time because each of a pension scheme's members is relying on their fund to give them enough money when they retire to buy a sufficient annuity - a financial product which guarantees the owner a fixed annual income for a period of time which, in the case of retirees is usually their remaining lifetime. Pensioners should be able to comfortably live off the income from their annuity for the rest of their life, as long as they've put enough money into it. Providing this level of financial security for ordinary people is a pension fund's primary aim and, in the current climate, a serious investment challenge.

With such significant financial responsibilities, pension funds are by far the single largest class of investors in the finance world. Not surprisingly then, the decisions pension funds make about what kind of assets to buy and sell have a significant impact on the markets.

Who's in charge of pension funds and where they invest?

1. Pension fund managers

There are asset management companies set up purely to manage pension funds, but the vast majority of consultancies and investment banks also offer expertise in this area for a fee and are widely used by the largest pension funds.

Because they have long-term income goals but also need to give existing pensioners a good return on their money, pension funds need a mixture of safe assets with steady returns and more risky high-yielding products in their portfolios. There's no set way to invest though, and that's why asset managers are there to oversee exactly what should be bought and sold, and when, because they (supposedly) have the market expertise to make good investment decisions. Pension fund managers also develop and sell complicated investment tools, such as derivatives which can reduce risk and optimise investment returns simultaneously.

The job is complex as the value of assets can change drastically as a result of market volatility, and because pension funds' objectives are ever-changing as they adjust to issues such as new legislation and longevity risk.

*2. Trustees *

If the investment ideas of asset managers are to become reality, they must win the approval of the gatekeepers of pension funds - the trustees.

Most occupational pension schemes are partly governed by trustees, who are employees of the company running the scheme. They're appointed because they have a vested interest in the future success of the scheme, but they usually don't have the expertise that fund managers have in devising complicated investment strategies. Instead, trustees bridge the gap between the fund managers as technical experts and the people whose retirement incomes are at stake.

Fund managers must present trustees with options which meet their criteria, and then it's up to the trustees to make the final decisions.

3. Individual investors

Individuals have a certain level of control over their own pension investments.

Pension schemes often allow their members to express their appetite for risk and will then allocate their money to suitable investments, so individuals therefore have a collective impact on the financial markets.

What do pension funds invest in?

There's a myriad of different things pension funds can invest in. You name it - and a pension fund is probably investing in it. Investments can range from wind farms in Yorkshire, to gold mines in China, to the company that invented Peppa Pig (which, I've been told by fund managers, is a particularly shrewd choice at the moment).

The assets that pension funds choose to invest in can be split into three main groups:

1. Equities

Pension funds generally put most of their money into domestic and international equities (shares) because these provide excellent returns over a long period of time. Equities can be risky in the short term as their value tends to fluctuate, but pension funds often choose to invest in businesses regarded as solid. For example, international consumer staples brands such as Johnson & Johnson or Unilever are considered good investments by pension funds as their businesses are expected to grow steadily in the coming years.

Most pension funds also invest in equities "passively", which means buying into an index, that is, a collection of various listed companies of a certain type or chosen to fit with a particular strategy. For example, the FTSE 100 index consists of shares in the 100 most highly valued companies listing their shares on the London Stock Exchange, while other indices may contain companies with interests in a particular industry sector or part of the world. There are thousands of different indices out there, all with slightly different characteristics and quirks to cater to the varying needs of different funds.

As scheme members move closer to retirement, schemes put their money into what's called a "lifestyle" plan, which essentially means placing it into very low-risk investments in order to ensure that there's little risk that any of the returns accumulated over the member's working life will be lost as they near retirement - as once the member stops working and needs to buy an annuity, there will be no more time for the value of their investment to rise again. Often all, or nearly all, of equity holdings are shed at this point.

2. Fixed income

The term fixed income originated as a term for products with fixed schedules of returns to investors, usually debt products, which provide fixed interest rate payments to investors at specific times, unlike equities, which don't provide guaranteed, regular payments to investors.

Today, the term fixed income is used to refer to debt, interest rate and foreign exchange products, as opposed to equities or commodities. The fixed income products that pension funds most often invest in are corporate bonds (tradeable slices of company debt) and gilts (UK and foreign government debt). Corporate bonds and gilts are considered safe bets because, while their returns aren't the best in the market, they are guaranteed.

When pension funds enter the "lifestyling" phase, their portfolio becomes very bond-heavy, with eventually up to 100 per cent invested in these and other fixed-income assets to eliminate the chance of the fund falling in value before the person scoops up their invested pot and turns it into an annuity.

3. Alternative investments

Property, infrastructure assets and cash are known as alternative investments because they stand outside the asset groups - fixed income and equities - in which pension funds usually invest. Only a relatively small amount of money is usually put into these types of assets by pension funds, with the largest ones with the most resources generally investing most heavily.