A pension fund is a pool of assets, typically comprising stocks, bonds, and other investments, that an employer has set aside to provide retirement income to its employees. These funds are invested with the goal of growing the assets so that there is enough money to pay the pension benefits when the employees retire.
There are two main types of pension funds:
- Defined Benefit Plan: In this type of plan, the employer promises to pay a specified amount to the employee upon retirement, regardless of the performance of the investments in the pension fund. The amount is typically based on the employee’s salary and years of service. The employer bears the investment risk, as they are obligated to pay the promised amount regardless of how the pension fund’s investments perform.
- Defined Contribution Plan: In this type of plan, the employer contributes a certain amount to the pension fund, but there’s no promise of a specific benefit upon retirement. The retirement benefit depends on the amount of contributions made and the performance of the investments in the pension fund. The employee bears the investment risk in this case, as their retirement benefit depends on the fund’s investment performance.
In addition to employer-sponsored pension funds, there are also public pension funds, which are established by governments to provide retirement income to public employees, and multiemployer pension funds, which are collectively bargained plans involving multiple employers, usually within the same industry.
Pension funds are subject to various regulatory requirements and are typically overseen by trustees or a board of directors to ensure that they are managed in the best interest of the employees. The investment strategy of a pension fund typically focuses on long-term growth and considers the need to balance risk and return.
Example of a Pension Fund
Let’s look at an example of each type of pension fund.
- Defined Benefit Plan: Company A promises its employees that when they retire, they will receive an annual pension equal to 2% of their final salary multiplied by the number of years they have worked for the company. For example, if an employee retires after 30 years of service with a final salary of $80,000, they will receive a pension of $48,000 per year (0.02 * $80,000 * 30). Company A is responsible for managing the pension fund and ensuring there is enough money to pay these pensions.
- Defined Contribution Plan: Company B contributes an amount equal to 5% of each employee’s salary to a pension fund every year. The funds are invested, and the employees will receive the balance in their account when they retire. The amount the employees receive will depend on how much has been contributed and how well the investments have performed. For example, if an employee earns $60,000 per year, Company B will contribute $3,000 to the pension fund on their behalf each year (0.05 * $60,000). If the pension fund’s investments perform well, the employee could end up with a substantial retirement nest egg.
In both examples, the companies have established pension funds to provide retirement income for their employees. However, the risk is borne by different parties. In the defined benefit plan, Company A bears the investment risk because it has promised a specific pension amount. In the defined contribution plan, the employees bear the investment risk because their retirement income depends on the performance of the pension fund’s investments.