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Pension funds are one of the primary methods individuals and households use to ensure financial stability and security during retirement.
By collecting contributions throughout an adult’s working life and investing them, they generally allow an individual to accumulate savings, provide income after retirement, as well as serving as a mechanism for long-term investment.
Retirement planning is one of the most important decisions an individual can take during their life – and the sooner that plan is established, the better. As one of the main components of a retirement plan, it is crucial for young workers to understand pension funds and how they work.
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A pension fund is a pool of capital made up of contributions by private or public sector employees (and, at times, employers), which is then managed by an investment professional – usually a fund manager.
Returns from the fund will be used to pay pensioners post retirement to help secure their financial future.
Pension funds operate under the principle of accumulating savings and investing them for long-term growth.
They are structured as long-term investment vehicles that prioritize sustainability and stability. As such, they generally tend to invest in long-term, stable, and less risky financial assets, such as bonds, and blue chip, dividend-paying stocks.
While yields on such assets may be small, they accumulate over time and through compound investing they can (usually) provide a nice income for retirees.
Pension funds play an outsized role in most Western and highly financialized economies (where pension funds are more common),
with pension funds usually being the biggest pool of investors in these countries. For most, they serve as a worker’s only exposure to financial markets.
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1- Contributions: Employees and / or employers pay contributions into a pension fund. These are usually taken out of their gross salaries.
2- Investment management: Pension funds are usually run by trustees and boards or government entities in the case of a public sector or union-based fund.
These then appoint an investment manager, depending on the objective of the fund. These run the gamut of a large investment bank to smaller hedge funds.
These generally charge commission and fees for managing the fund. As noted above, these funds prioritize long-term, stable investments. As such, they are generally well-diversified across a number of asset classes to spread out and hedge against risk.
3- Growth accumulation: contributions invested are expected to grow over time through compound investing and growth.
4- Payouts: Pensioners receive their payouts based on the fund’s structure. Funds can have a fixed benefit structure, which pays out a steady amount, or market-based, where payouts are based on market performance (more on that below). Payments may come in the form of a lump sum, annual payouts or regular withdrawals.
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Pension funds are generally divided into two categories:
A defined benefits plan provides retirees with a fixed payout that takes into account the pensioner’s years of service, salary history, and age of retirement.
This usually requires the employers to payout pensions to the retirees regardless of the performance of the pension fund, and serves as a guaranteed payment for the pensioner. Any shortfalls in the fund will be covered by the employer.
A defined contribution plan provides pensioners with payouts that are directly correlated to the performance of the market, such as a 401K in the US.
Unlike with a defined benefits plan, the employee bears the risk of any losses to the pension fund, making it imperative that the fund is managed by a qualified investment professional.
These pension funds however, do offer the pensioners choice in the management and investments, and pensioners typically act as joint owners of the fund.
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Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
