Pension funds

Overview

A pension fund is a pool of money that is made up of people’s contributions over people’s working lives, which is invested to provide sufficient income to people after retirement. 

In the UK, it is important to note that there are two types of pension schemes which are Defined Benefit (DB) schemes and Defined Contribution (DC) schemes. DB schemes work when an employer promises a set income in retirement regardless of how underlying investments perform, which is becoming increasingly unpopular in modern times, whilst a DC scheme is when both the employer and employee contribute to a pot of money, and at retirement, the amount is paid out, with the amount depending on how much money was contributed and investment performance. 

Examples 

• Nest: Nest is the UK's government-backed workplace pension scheme, which supports auto-enrolment for smaller employers. 
• The Universities Superannuation Scheme (USS): The USS is the main pension scheme for UK academic staff, but has typically been a source of repeated strike action because of funding issues. 
• The Local Government Pension Scheme (LGPS): The LGPS covers council employees across the UK. 
• CalPERS (the California Public Employees' Retirement System): Globally, CalPERS is usually recognised as the world's most closely watched pension fund because of its sheer size and the influence it holds over companies it invests in.

How they work

Contributions from employees and employers accumulate over a working career, with the money being invested and able to grow, usually over several decades. 

In a DB scheme, the employer bears all the investment risk, which means if the fund's assets underperform, the employer has to contribute more to keep promised pension payments stable. 

However, in a DC scheme, the individual is the one who bears the investment risk since whatever is left at retirement is whatever the investments have generated since being in their pot. 

Investment strategy

Pension funds will know roughly when they have to start paying out of their fund and for how long on average based on life expectancy at the time, so they aim to match long-dated liabilities with longer-duration assets such as bonds, equities, and increasingly private equity. 

Liability-Driven Investment (LDI) is a common strategy among UK DB schemes that uses derivatives to hedge against inflation and interest rate moves that would disturb the fund's assets. 

However, in September 2022, it became front-page news when a rapid rise in UK gilt yields due to the Truss mini-budget forced funds to sell gilts to meet margin calls, pushing the yield prices even higher. 

Institutional role

Pension funds are one of the largest sources of long-term capital in finance, with a large share of the money that flows into hedge funds and private equity firms originating from pension schemes seeking higher long-term returns than what would be typically achieved in public markets. 

Regulation

The Pensions Regulator (TPR) is the body that regulates UK workplace pension schemes. It does this by setting requirements that DB schemes must meet to ensure they can pay promised benefits and enforcing automatic enrolment rules, requiring employers to enrol eligible staff into a workplace pension by default. 

Risks and criticisms

• Funding deficits: DB schemes in the UK have faced persistent funding deficits, particularly after the years of low interest rates that invalided the present value of their future liabilities. 
• Longevity risk: life expectancy has got better, so the actuarial assumptions that have been predicted are increasingly wrong, thus adding further pressure on the funds. 
• Investment risk: The broad shift from DB to DC schemes across the private sector in the UK has passed investment risk from employers onto individuals, which has fuelled a debate about retirement adequacy. 
• ESG: Pension funds are increasingly being scrutinised over how they use voting power on ESG since they are major shareholders and can have vast influence over listed companies.