How Are Pensions Funded?

Pension plans are provided by employers to provide for employees’ retirement income. Usually, they set aside an amount and invest it in a multitude of assets for diversification and returns. Over the years, pension plans have changed from being very conservative to slightly more focused on higher returns. As a result, they have a higher risk appetite. 

How do pension plans get funded? What are the different kinds of pension plans? What is the difference between a pension plan and a 401(k)? 

A pension fund is a fund, scheme, or plan that provides for employees’ retirement income. These funds have large amounts of money at their disposal for investment. However, the assets in these funds need to be managed prudently so that employees can get the promised benefits when they retire. 

The key to investing under pension funds is to be diversified. A public pension fund is regulated under public sector law and provided to people working in federal, state, and local governments. All other retirement income from pensions is considered private. 

Traditionally, pension funds used to invest very conservatively in relatively safer investments like government securities, investment-grade bonds, and blue-chip stocks. However, with time, the funds have been allowed to invest in other asset classes as well to enhance the return profile. These alternative investment classes include hedge funds, commodities, private equity, derivatives, and high-yield bonds. 

The proportion of alternative assets in pension funds’ portfolios is rising. According to the AIC (American Investment Council), private equity continues to be the top-performing asset class for public pension portfolios. According to the 2019 report, private equity accounted for 8.7 percent of public pension portfolios on a dollar-weighted basis. 

 The pension funds with the largest investments in private equity in 2019 were: 

• California Public Employees’ Retirement System 
• Teacher Retirement System of Texas 
• Washington State Investment Board 
• California State Teachers’ Retirement System
• New York State Common Retirement Fund

However, since pension funds have to make good on their promises to give retirees a certain level of income, they have to be conservative in their approach as well. A large part of public pension funds’ portfolios is still invested in fixed income securities and blue-chip stocks. 

A pension plan could be funded or unfunded based on the level of assets and income. A funded plan has enough assets to cover current and future foreseeable payments. Its assets can provide for the accrued benefits it owes to employees. In contrast, unfunded plans don't have enough assets to cover the accrued benefits it owes. 

In funded plans, the funds usually have enough money in hand and in investments, which along with the return on investment is enough to cover all of the obligations. Unfunded pension plans are also referred to as pay-as-you-go plans. Employers decide on regular deductions from their income or lump sum payments periodically towards the fund. Apart from fully funded and unfunded pension plans, there are also hybrid plans that are partially funded. 

For example, the U.S. Social Security system is partially funded by investment in U.S. Treasury bonds. The American state pension system is financed through social security taxes paid by employers and employees, which account for 84 percent of the funding. The rest of the 16 percent funding is paid through tax revenues collected from upper-income social security beneficiaries and interest earned on accumulated trust fund reserves.  

A pension plan and 401(k) might sound similar since both of them are used as retirement vehicles. However, they are very different. Pension plans are mainly defined benefit plans that provide a specified sum at retirement. In contrast, a 401(k) is like a defined contribution plan where only the contributions made are specified. 

Under a defined contribution plan, employees paid a fixed amount set aside periodically, while the employer can choose whether or not to contribute to it. For defined benefit plans, employers guarantee a specified amount for employees and also bear the risk for providing it. Therefore, the major difference lies in who bears the investment risks. Nowadays, the 401(k) seems to be replacing pension plans.  

Another major difference between a pension plan and 401(k) is the control over fund contributions. In the 401(k), employees can control the size of the contributions and investment decisions. In pension plans, employees don’t have any control.