Retirement - The Tips You Must Learn

Pension funds, which can be defined as financial intermediaries, usually sponsored by non-financial companies, which collect and invest funds on a pooled basis for eventual payment to members in the form of pensions, are among the most important institutions in certain national financial markets. For example, in 1991 in the USA, pension funds held 26% of equities, in the Netherlands private pension funds accounted for 26% of personal sector assets, and in Switzerland their assets were equivalent to 70% of GDP. In contrast, in other advanced industrial countries such as France, Germany, and Italy, funds are of minor importance.

Pension funds are of two main types–namely, defined benefit and defined contribution–which differ in the distribution of risk between the member and the sponsor (typically a non-financial company). In the former, the sponsor undertakes to pay members a pension related to career earnings, such as a predetermined percentage of final or average salary, subject to years of service, or a flat benefit per year of service. Hence members trade wages for pensions at the long-term average rate of return in the capital market, while employers bear the investment risk, paying benefits even if the fund proves inadequate. In practice, this usually entails an undertaking to top up the fund when assets decline in value or liabilities increase, to keep it in actuarial balance (note that liabilities may increase not merely because of higher pension claims but also because of a fall in the long-term interest rate at which liabilities are discounted). This risk-sharing feature is absent from defined-contribution schemes, where contributions are fixed and benefits vary with market returns; all the risk is borne by the employee. In the case of a stock-market crash just prior to retirement, such risks for defined-contribution plans may be severe—pensioners.

The main features of pension funds can be analysed partly by contrasting them with other types of provision for old age and financial institution. Hence, unlike pay-as-you-go pension funds, where workers' contributions are paid direct to pensioners, large quantities of funds are accumulated by or on behalf of workers to pay their own pensions, and there is no intra- or intergenerational transfer or redistribution.

Unlike social security, company pensions are highly adaptable to varying circumstances and levels of cover that may be required. Again, provision of pension funds is usually voluntary for companies; hence, coverage is usually much lower than for social security, except in countries such as Switzerland and Australia, where provision of private pensions is compulsory. Unlike banks, pension funds benefit from regular inflows of funds on a contractual basis and from longterm liabilities (i.e. with no premature withdrawal of funds), which together imply little liquidity risk. The main risks are rather those of inaccurate estimates of mortality and lower than expected returns on assets. Definedbenefit pension schemes may also suffer from the influence on liabilities of unexpected changes in salaries, transfer payments out of the scheme, and legal changes (e.g. equal retirement ages).

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