Pension Investments: Where Your Money Goes

Pension funds are a major source of investment in the stock market and are important investors in listed and private companies. They are designed to grow over time and are made up of a range of different asset classes. The main asset classes are bonds, cash, commodities, company shares, and property. Pension funds are managed with the goal of ensuring that retirees receive the benefits they were promised. Pension funds have traditionally invested in stocks and bonds, but they are increasingly investing in a variety of other asset classes, including private equity, real estate, infrastructure, and securities like gold.

Stocks and shares

Share prices are influenced by current market conditions, historic performance, and potential growth opportunities. The price of a share is the value of the company divided by the number of shares issued.

Historically, pension funds have primarily invested in blue-chip stocks, but the search for higher returns has pushed some fund managers into riskier small-cap growth stocks and international equities.

In the US, stocks were a larger financial asset for households than pensions in the 1950s, 60s, and since 2018.

Bonds

Pension funds invest in government securities, investment-grade bonds, and corporate bonds. In the US, pension funds are increasingly investing in high-yield bonds and well-secured, commercial real estate loans. However, these carry a greater risk than typical corporate or government bonds.

Pension funds can also issue their own bonds. This can be a credible proposition for pension funds with the size and scale to do so. However, it is a challenging process, as pension funds also have liabilities that make it more difficult.

Real estate

Pension funds have been investing in real estate for decades, recognising the important role it plays in helping to build a diversified portfolio and manage risk. Real estate is considered a "hybrid" investment, demonstrating characteristics of both bonds and stocks. It provides a stable and consistent income, with the opportunity for capital appreciation.

Pension funds invest in a variety of real estate types, including single-family homes, multifamily homes, commercial properties, and retail real estate. Commercial real estate, in particular, is a substantial component of the investment opportunity set in the United States, making up the third-largest asset class.

There are several advantages to investing in real estate for pension funds:

• Diversification: Real estate returns have a low correlation with the investment returns of other assets, helping to increase portfolio diversification.
• Stable and consistent income: Real estate provides a steady income stream, similar to bonds, with the potential for capital appreciation like stocks.
• Inflation protection: Real estate tends to outperform the market during inflationary times, as property prices and rental income tend to rise with inflation.
• Low interest rates: Low-interest rates make it easier for individuals to borrow money and invest in the real estate market, leading to rising property prices.
• Incremental cash flows: With rental rates growing consistently, investing in real estate provides pension funds with incremental cash flows.

However, there are also some disadvantages to consider:

• Difficult to manage: Real estate investments require active participation from investors, as finding tenants and managing properties can be challenging and time-consuming.
• Higher taxation: Pension funds do not receive the same tax breaks as individual investors when investing in real estate, leading to higher tax rates.
• Difficult to liquidate: Real estate is not a liquid asset, and the liquidation process can be tedious and time-consuming, with high transaction costs.

Overall, while real estate has traditionally been a small portion of pension fund portfolios, its importance as an investment asset has been increasing due to the strong real estate market, particularly in North America.

Commodities

Pension funds have traditionally been limited to investing in government securities, investment-grade bonds, and blue-chip stocks. However, changing market conditions have led to a shift towards alternative investments, including commodities. This shift was accelerated by the 2008/2009 global financial crisis, which caused heavy losses for pension funds with equity-heavy portfolios.

Furthermore, commodities are currently trading at low prices and are often poorly-researched, making them an excellent opportunity for active managers to add value.

Pension funds typically invest in commodities through managers who arrange ownership of assets such as farmland or mines. They may also gain exposure to commodities through managed futures funds, also known as commodity trading advisors (CTAs).

Private equity

Pension funds are one of the largest sources of capital for the private equity industry. Private equity can boost returns for target-date funds in workplace pension plans, according to a Georgetown study. This is because private equity involves investing in illiquid assets, which can be advantageous for retirement savers.

Pension funds have traditionally invested in stocks and bonds, but changing market conditions have encouraged investment in other asset classes, such as private equity, real estate, and infrastructure. Private equity is a long-term investment strategy that can provide pension funds with diversification and the potential for high returns.

Frequently asked questions