by The assets of company pension plan also represent an important store of cash generating wealth, which under IAS 19 Employee Benefits are to be valued at fair value. These are, however, slightly different in that they do not (yet) appear directly in the balance sheet of the employer’s company but are offset against the pension obligation, and the net figure is shown. Plan assets occur when a company operates a defined benefit pension plan. This is a scheme where pensions are paid usually by reference to the employee’s salary when they retire or an average salary over a period. During employment, the employer company builds up a liability (pension obligation) for the amounts it will subsequently pay to the retired employee. This obligation is measured according to rules set out in the standard and is not at fair value as such.
The employer may put assets into a separate fund to meet the pension obligation. These assets, known as plan assets, are usually ring-fenced from the company and are not shown in the company balance sheet at present, even though some people think they should be. However, they do figure indirectly in the balance sheet because IAS 19 requires the employer to disclose the value of the pension obligation and the plan assets in the notes to the financial statements and then take the difference between the two into the balance sheet.
Pension fund assets need to be prudently managed to ensure that retirees receive promised retirement benefits. For many years this meant that funds were limited to investing primarily in government securities, investment grade bonds, and bluechip stocks.
Changing market conditions and the need to maintain a high-enough rate of return have resulted in pension plan rules that allow investments in most asset classes. These are some of the most common investments to which pension funds allocate their substantial capital. Here, we take a look at some of the asset classes that pension funds are likely to own.
Inflation Protection
Inflation protection is a term used to refer to assets that tend to go up in value as inflation ramps up. These may include inflation adjusted bonds (e.g. TIPS), commodities, currencies, and interest-rate derivatives. The use of inflation adjusted bonds is often justified, but the increased allocation of pension fund assets in commodities, currencies, or derivatives has raised concerns by some due to the additional idiosyncratic risk that they carry.
Liability matching, also known as “immunization“, is an investment strategy that matches future assets sales and income streams against the timing of expected future expenses. The strategy has become widely embraced among pension fund managers, who attempt to minimize a portfolio’s liquidation risk by ensuring asset sales, interest, and dividend payments correspond with expected payments to pension recipients. This stands in contrast to simpler strategies that attempt to maximize return without regard to withdrawal timing.
Fixed Income Investments
U.S. Treasury securities and investment grade bonds are still a key part of pension fund portfolios. Investment managers seeking higher returns than what is available from conservative fixed-income instruments have expanded into high yield bonds and well secured commercial real estate loans. Portfolios including asset backed securities (ABS), such as student loans and credit-card debt, are increasing. However, the risk associated with those securities tends to be quite a bit greater than typical corporate or government bonds.
As an example of the prevalence of fixed-income securities in pension portfolios, the largest pension plan in the US the California Public Employees’ Retirement System (“CalPERS”), seeks an annual return of 7%,1 with approximately one-third of its $385.1 billion portfolio was allocated to fixed-income investments as of March 2020.
Private Equity
Institutional investors, such as pension funds, and those classified as accredited investors invest in private equity a long-term, alternative investment category suited for sophisticated investors. In fact, pension funds are one of the largest sources of capital for the private equity industry.
In its purest form, private equity represents managed pools of money invested in the equity of privately-held companies with the intention of eventually selling the investments for substantial gains. Private equity fund managers charge high fees based on promises of above-market returns.
Real Estate
Pension fund real estate investments are typically passive investments made through real estate investment trusts (REITs) or private equity pools. Some pension funds run real estate development departments to participate directly in the acquisition, development, or management of properties.
Long-term investments are in commercial real estate, such as office buildings, industrial parks, apartments, or retail complexes. The goal is to create a portfolio of properties that combine equity appreciation with a rising stream of inflation-adjusted income to balance the ups and downs of the markets.
Stocks
Equity investments in U.S. bluechip common and preferred stocks are a major investment class for pension funds.
Managers traditionally focus on dividends combined with growth. The search for higher returns has pushed some fund managers into riskier small-cap growth stocks and international equities.
Larger funds, such as CalPERS, self-manage their stock portfolios. Smaller funds are likely to seek outside management or else invest in institutional versions of the same mutual funds and exchange traded funds (ETFs) as individual investors. The prime difference here is that the institutional share classes do not have front-end sales commissions, redemption, or 12b-1 fees, and they charge a lower expense ratio.
