Pension Fund: Overview & How It Works
A pension is the money you live on once you have retired. That’s everything you have accumulated over the course of your working life.
People save and invest money for future consumption. The primary aim of life-time savings is to maintain standard of living after retirement.
People’s attitute towards risk shifts from risk tolerance to risk aversion as they near retirement age.
For example, one simple rule suggests the following allocation based on age:
- % Allocated to Fixed Income = Age
- % Allocated to Equity = 100 – Age
- Application to a 30 year-old professional: Fixed Income (30%) + Equity: (70%)
Pension Fund
Pension fund is the cumulation of assets created from contributions by employee and employer, investment earnings, and payment of benefits.
Contribution: Workers and their employers pay a certain % of salary to the fund
Investment Earnings: Money in the fund is invested and managed on behalf of future retirees
Benefits: Upon retirement, typically, a person starts to receive a retirement salary, which is a certain % of pre-retirement salary, called “replacement rate” in the pension jargon.
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The most common pension plans are defined contribution plan and defined benefit plan. The defined contribution plan specifies the payments to the plan, but not the eventual benefits because the person bears the investment risk. These plans are funded, meaning there is money in the pension fund.
Defined benefit plan specifies the benefit (retirement salary); thus the plan sponsor (company or state) bears the risk. Most defined benefit plans are unfunded, meaning there is a promise to pay retirement salaries.
In defined benefit plans, invest in bonds that match the promised benefit payments. Pension funds prefer long term bonds to eliminate re-invesment risk.
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Penfion funds allocate 40-60% to equities to participate in the long term growth of the economy. In defined contribution plans, asset allocation is up to the individual. However, most people are either not sophisticated or not interested in making allocations.
A simple solution is target-date retirement fund which reduces proportion invested in stocks and increases bonds as time passes.
Final Thoughts
Retirement is a hard-earned reward for a lifetime’s work. When you get older, you should guarantee your income by choosing the best pension plans to ensure a comfortable retirement.
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