Saturday, August 29, 2009

Investment strategies of pension funds

Pension funds are long-term investors with little need for liquidity. their incoming cash receipts are known with great accuracy since a fixed percentage of each employee‘s salary is usually contributed to the fund. At the same time, cash outflows are relatively easy to forecast because benefit payments are stipulated in the contract between the fund and its members. This situation encourages pensions to purchase common stock, long-term bonds, and real estate and hold these assets on a more-or-less-permanent basis. In addition, interest income and capital gains from investments are exempt from federal income taxes, while pension plan members are not taxed on their contributions unless cash benefits are paid out.
While favorable taxation and predictable cash flows favor longer-term somewhat riskier investments, the pension fund industry is closely regulated in all of its activities, including the investing of funds. The employee retirement Income Security Act of (ERISA) requires all private plans to be funded, which means that any assets held plus anticipated investment income must be adequate to cover all promised benefits. ERISA also requires that investments must be made in a "prudent" manner, which is usually interpreted to mean highly diversified holdings of high-grade common stock, corporate bonds, and government securities with only limited real estate investments.
While existing regulations do emphasize caution and conservatism in pension fund investments, the private plans have been under intense pressure in recent years by both management of the sponsoring company and employees to be more liberal in their investment policies. The sponsoring employer has a strong incentive to encourage its affiliated pension plan to reduce operating expenses and earn the highest possible returns on its investments. This permits the company to minimize its contributions to the plan. Both sponsoring employers and employees have a keen interest in seeing that the pension plan earns a high enough return on its investment to at least keep pace with inflation. Otherwise, the employees will tend to seek other jobs whose pension programs offer more lucrative returns.

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