Individual investors are well aware of the existence of pension funds. Retail investors who earn their income in the form of a salary are likely to have invested in these funds. Other retail investors may also have invested in these funds. Almost everyone has heard about pension funds in the news. However, very few people are aware of the power and importance that modern-day pension funds yield in the investment universe. In this article, we will have a closer look at why pension funds are important for the overall global economy.
Pension Funds are Huge in Size
The first thing to know about pension funds is that they wield enormous economic power. It has been estimated that pension funds around the world account for assets worth more than $56 trillion! This is a very large amount of money and is comparable to the amounts owned by other big funds such as mutual funds, hedge funds, and sovereign funds. Also, pension funds have a predictable inflow of funds.
Most people contribute a fixed amount of their income each month to pension funds regardless of the external economic environment. This is quite different compared to other financial vehicles such as mutual funds wherein the quantum of investment changes with the external environment. Pension funds have more money than the GDP of entire nations. This is what makes them an economic powerhouse.
Pension Funds Have the Potential to Move Markets
From the above point, we already know that pension funds have a huge amount of money invested in various financial markets. Hence, when they rebalance their portfolio, significant movements happen in the markets.
For example, if the Fed raises interest rates, the pension funds might find it more lucrative to invest their money in bonds. Hence, they will exit the stock market and enter the bond market. Since the scale of their purchase and sale is so large, they tend to have a huge impact on the overall financial markets. Many times, this impact is not limited to national boundaries and impacts other markets and economies as well.
Pension Funds Make Long Term Investments
An important point related to pension funds is the fact that these funds invest for the very long term. For the individual investor, pension funds are highly illiquid. They cannot exit these funds in the short run. This is in contrast with other funds such as mutual funds and hedge funds where investors can enter and exit at will. Now, since pension funds invest for the very long term, they tend to have a stabilizing effect on the entire market.
Companies, industries, and sometimes entire countries try to woo pension funds since the stable nature of these investments helps in stabilizing security prices which in turn helps these entities take decisions without the added pressure of meeting short-term investor requirements.
Pension Funds Impact Government Budgets
Pension funds are closely intertwined with government budgets. This is because a large amount of money is directly contributed by government-administered pension funds. However, more importantly, pension funds provide social security to people. The government is also responsible for providing social security to its citizens.
Hence, if a pension fund fails, the responsibility of providing for their day-to-day expenses and medical care will fall on the government. This makes the government an important stakeholder of pension funds. Governments want to ensure that pension funds invest their money only in safe assets. This is the reason that governments tend to keep a close eye on the investments made by these funds using extensive regulation and reporting requirements.
Pension Funds are Impacted by Demographics
Pension funds are linked with the underlying demographics of any nation. If a nation has a high number of young people, then there will be more people contributing to these funds, and the funds will remain invested for a longer time. On the other hand, if there are more people who are withdrawing money from the fund, then are investing money into the fund, then the total assets under management will decrease. If the amount of assets being managed goes down, then as mentioned above, it can have an impact on the overall financial markets of a country. It can be said that pension funds link the demographics of a country with its financial markets.
Pension Funds Drive Financial Innovation
Investment bankers are aware of the huge investment potential that pension funds have. Hence, they want to tap these funds as and when possible. Since pension funds are not allowed to invest in securities that are below investment grade, investment bankers have to use financial innovation. There are many instances where investment banks have used techniques such as credit enhancement and tranching in order to make the underlying investment more palatable to pension funds.
Mortgage-backed securities are an example of such innovation. Investment bankers create different tranches of securities with different risk-return profiles so that they can market the investment-grade securities to pension funds. Hence, it can be said that pension funds indirectly drive innovation in the financial markets.
The bottom line is that pension funds are very powerful institutions. Their actions can impact different types of financial markets, governments, and people in general. This is the reason that they are considered to be quite important and the funds under their management are extensively regulated.