Pension Funds: Where Your Money Is Invested

Pension funds are financial intermediaries that invest contributions to provide retirement income for members. They are the largest investment blocks in most countries and are exempt from capital gains tax. Pension funds have traditionally been limited to investing in government-backed securities, such as bonds and blue-chip stocks, but changing market conditions have led to a shift towards other asset classes, including private equity, real estate, and infrastructure. Pension funds aim to diversify their portfolios to minimise risk and maximise returns, with the ultimate goal of ensuring there is enough money to cover the pensions of employees after retirement.

Stocks and bonds

Pension funds have traditionally invested in stocks and bonds, but they are increasingly moving towards other asset classes. Stocks and bonds are still a key part of pension fund portfolios, with pension funds investing large pools of money into private and public companies.

However, market changes have meant that pension funds are now allowed to invest in most asset classes. Pension funds have been branching out into other investments, such as private equity, real estate, and infrastructure. This is largely driven by the hunt for higher returns and the need for portfolio diversification to reduce overall risk.

Pension funds are also increasingly investing in asset-backed securities (ABS) such as student loans and credit card debt. The risk associated with these types of securities is greater than with stocks and bonds.

Historically, pension funds were limited to investing in government-backed securities, such as bonds with a high credit rating (investment-grade bonds) and blue-chip stocks. They also used a liability-matching strategy, which matches future asset sales and income streams with the timing of expected future expenses.

Pension funds are now investing in riskier stocks, such as small-cap growth stocks and international equities, in search of higher returns. They are also investing in high-yield bonds and well-secured, commercial real estate loans.

Private equity

Pension funds have traditionally been limited to investing in government-backed securities, investment-grade bonds, and blue-chip stocks. However, changing market conditions and the need to maintain sufficiently high rates of return have led to a shift in investment strategies. Pension funds are now increasingly investing in private equity, making them one of the largest sources of capital for the private equity industry.

Pension funds are attracted to private equity due to its potential for superior returns and its ability to provide a more stable investment option compared to the volatile public markets. The complexity and opacity of the private market benefit pension funds, as investors are not influenced by the short-term fluctuations that are common in public markets.

The private equity industry is also maturing and becoming more diverse, with a new breed of boutique funds specializing in specific sectors or geographies, allowing institutional managers to better spread their risk. Additionally, advancements in technology and specialized personnel are making private equity a more attractive and manageable investment option for pension funds.

Overall, private equity is becoming an increasingly popular investment choice for pension funds, offering the potential for strong returns and long-term capital appreciation.

Real estate

Pension funds have long recognised the value of real estate investments, which contribute to portfolio diversification and risk management. Real estate investments can take the form of equity or debt and can be accessed through private or public market structures. While direct property investment and private commingled funds are options, REITs (Real Estate Investment Trusts) are often the most efficient and cost-effective way for pension funds to access the real estate asset class.

REITs, traded on major stock exchanges, offer high dividend income, long-term capital appreciation, and low correlation with other assets, making them an excellent portfolio diversifier. They also provide transparency and help manage overall investment costs.

Pension funds are increasingly investing in real estate, with allocations ranging from 8% to 20% of their portfolios. This trend is driven by several factors:

• Low-interest rates: Low borrowing costs increase returns on real estate investments.
• Rental growth expectations: Investors anticipate rental growth in various niches, driving overall returns.
• Abundant capital: Agency debt from Fannie Mae and Freddie Mac provides easy access to capital for investors.
• Inflation hedge: Real estate values and rental incomes tend to rise during inflationary periods.

However, real estate investing is not without its challenges. It is a relatively illiquid asset, making it difficult to efficiently implement strategic moves or tactical adjustments. Additionally, managing physical assets can be cumbersome, leading some investors to opt for private real estate funds or REITs to avoid hands-on stewardship.

Despite these challenges, real estate remains an attractive investment option for pension funds due to its stable income, inflation protection, and diversification benefits.

Infrastructure

Pension funds have traditionally invested in "core assets" such as money market instruments, government bonds, and large-cap equity. However, in recent years, pension funds have started to invest in infrastructure as a non-traditional asset class. Infrastructure investments include public and private developments in power, water, roads, and energy.

Historically, infrastructure investments represented only 1% of total assets under management by pensions, excluding indirect investment through ownership of stocks of listed utility and infrastructure companies. However, this has started to change due to a combination of factors. Firstly, governments have disengaged from costly long-term financial commitments to infrastructure projects following the 2008-2012 global recession. Secondly, infrastructure offers advantages such as long duration, facilitating cash flow matching with long-term liabilities, protection against inflation, and statistical diversification. These factors have prompted an increasing number of pension executives to consider investing in infrastructure.

Pension funds, including superannuation schemes, account for approximately 40% of all investors in the infrastructure asset class. Large Canadian pension funds and sovereign investors have been particularly active in energy assets such as natural gas and its infrastructure, becoming major players in recent years. In 2011, the British government unveiled a plan to encourage large-scale pension investments in roads, hospitals, and airports across the UK, aiming to attract £20 billion ($30.97 billion) in investment over the next decade.

While infrastructure investments by pension funds are a growing market, they still represent a small part of most pension-plan assets. These investments require large sums of money and long-term commitments. Pension funds that invest in infrastructure must be supported by transparent and long-term regulatory frameworks to ensure stable investment environments.

Inflation protection

Pension funds have long planning horizons and multi-decade liabilities, which means that inflation can have a significant impact on their portfolios. To protect against inflation, pension funds can invest in assets that tend to increase in value as inflation rises, such as inflation-adjusted bonds (TIPS), commodities, currencies, and interest-rate derivatives.

One way to hedge against inflation is to invest in real assets, such as certain stocks, real estate, or commodities. These assets can provide some inflation protection if the companies are able to increase prices or if the rental income is linked to inflation indices. For example, the Dutch pension fund for self-employed medical specialists, SPMS, has a large focus on inflation and invests in shares, alternatives, and real estate to protect against rising inflation.

Another strategy is to invest in a diverse range of asset classes, such as property, equities, and bonds, which can provide a natural hedge against inflation. For instance, investors can add corporate bonds and emerging market bonds to their portfolios, as these tend to have higher yields and offer some protection against inflation. The Finnish multi-employer pension fund, Ilmarinen, follows this approach and has an allocation of roughly 37-38% to fixed income, with an additional exposure of more than 9% to real estate.

Inflation-linked bonds can also be used to protect against inflation, although they carry the risk of rising real interest rates. Ilmarinen holds a small portion of these bonds, while APK Pensionskasse has minor exposure to them.

Additionally, pension funds can benefit from the mismatch between their assets and liabilities. For example, if inflation rises, interest rates will also rise, offering partial protection against higher inflation. This strategy is employed by SPMS, which has a higher indexation capacity than its current inflation rate.

Overall, by investing in a variety of assets and considering the potential impact of inflation on their portfolios, pension funds can protect their investments and ensure that retirees receive their promised benefits.

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