Pension funds have a very large amount of money at their disposal. However, that does not mean that the management of these funds can deploy this money as per their will. Pension funds are highly regulated and the asset classes in which they can invest in are limited. Over the years, the limitations have been relaxed and pension funds have obtained more freedom.
This article will provide an overview of the different asset classes in which pension funds can invest.
Investment and Risk Policy
It is important for any pension fund to clearly and concisely spell out its investment policy. This investment policy needs to be in line with the overall objective of any investment fund i.e. planning for retirement. Conventionally, funds for retirement planning are deployed in low-risk investments which have tax advantages. It is important for pension funds to ensure that the risk profile of their investments stays in line with the expected risk profile for a pension fund.
Asset Allocation Strategy
It is also important to note that pension funds have a clearly demarcated investment limit when it comes to different asset classes. Pension funds aim to make low-risk investments. When investments are diversified across a wide variety of asset classes, it is considered to be less risky. Hence, pension funds have limits that prohibit them from having excessive exposure to either a single asset class or a single issuer.
Different Types of Asset Class Allowed for Pension Funds
Here is a list of the different types of asset classes that are allowed for pension funds:
- Fixed Income Securities: Fixed income securities are the biggest asset class for any pension fund asset manager. This is because fixed income securities are considered to be amongst the safest investment options. However, these securities also provide very low returns. This is the reason that a high allocation towards fixed-income securities tends to lower the return of the entire portfolio. In order to overcome this problem, pension funds have started investing in exotic fixed income securities which are considered to be investment grade.
Pension funds have large-scale investments in mortgage-backed as well as asset-backed securities. These securities tend to be riskier as compared to traditional fixed-income securities. However, they also provide a higher rate of return. Modern-day pension fund investors do not mind taking the additional risk as long as they are compensated with better returns in the long run. The regulations in many parts of the world still do not allow pension funds to invest in exotic fixed income securities. In such cases, they have to remain invested in traditional fixed income securities.
- Equities: Equities are another important component of the pension managers portfolio. However, the allocation towards equity is generally less as compared to the allocation towards other assets. This is because equities are considered to be risky whereas the goal of pension managers is to take a conservative approach towards investing. Pension funds generally only invest in blue-chip stocks.
The investment philosophy of most pension funds prohibits them from taking positions in small and mid-cap stocks. However, over the years, pension funds have started investing in international blue-chip stocks in order to obtain better returns.
In most parts of the world, governments restrict the amount of capital that pension funds can take out of the country. In the past few years, this percentage has increased. Earlier, pension funds were only allowed to invest about 5% of their total portfolio in international assets. Over the years, this number has been steadily increasing and is now closer to 30%.
- Real Estate and Infrastructure: Pension funds all over the world have significant investments in the real estate sector. Over the years, this investment has mostly been made in the form of securities issued by real estate investment trusts. However, over the years, pension funds have started taking more risks. They now have entire departments dedicated to the acquisition, construction, sale, and leasing of real estate projects.
Over the years, pension funds have also started investing in infrastructure projects. Infrastructure projects such as roads, bridges, ports, etc. have a long gestation period. Since pension funds can afford to make very long-term investments, they are well suited to making these investments. Pension funds might issue debt to complete infrastructure projects. On the other hand, it is also possible that pension funds might buy equity in such projects and earn money from the cash flows generated from the project.
- Derivatives: A very small portion of the portfolio of pension funds can be used to purchase derivatives as well. This is done in order to hedge any foreign exchange or other exposure that the pension fund may have. In most cases, the investment philosophy of the pension fund clearly states that the fund cannot use derivatives for speculative purposes. Hence, it is imperative that pension funds have exposure to a certain asset class before they purchase a derivative in order to hedge that exposure.
The bottom line is that pension funds are allowed to invest in a wide variety of asset classes. They have to maintain their investments within the prescribed upper limits. Also, pension funds need to ensure that they only invest their money in the highest-rated assets in every asset class.