The pension fund operates on a funded basis. Contributions are set aside and invested during the beneficiaries’ working lives. Future pensions then depend on the plan’s rules, the contributions received, the length of the savings period, and—depending on the plan—the financial returns generated.
Understanding how a pension fund operates enables a savvy investor to analyze the role these players play in the public markets, infrastructure, real estate, and private equity. Their long-term investment horizon does not eliminate market risk, liquidity risk, or the risk of asset shortfalls.
How does a pension fund work?
Collection of Dues
The pension fund is financed by contributions made during a person’s working life. These contributions may come from:
- of the employee;
- by the employer;
- both of them together;
- a professional organization;
- more rarely, from public funding.
Contribution rules are set by the plan. The amount may be a percentage of salary, a lump sum, or a combination of several methods.
Suppose an employee earns a gross annual salary of 50,000 euros and the plan provides for a total contribution rate of 10 percent, including both the employee’s and the employer’s shares. The fund then receives 5,000 euros per year to finance this beneficiary’s future benefits.
Capital Investment
Contributions are not immediately paid out to retirees. They are accumulated in a portfolio composed of various asset classes:
- sovereign and corporate bonds;
- listed stocks;
- real estate;
- infrastructure;
- private debt;
- Private Equity;
- Cash and monetary instruments.
The allocation depends on the age of the beneficiaries, the duration of the commitments, regulatory requirements, the fund’s financial situation, and its ability to withstand market fluctuations.
A fund whose beneficiaries are primarily young people generally has a longer investment horizon than a fund that must pay out a large amount in pensions immediately. It can therefore consider a different asset allocation, although this long-term horizon does not guarantee a positive return.
Payment of Benefits
Upon retirement, benefits can be paid in several forms:
- a regular income;
- capital;
- a combination of annuity and lump-sum payments;
- benefits calculated based on salary and length of service.
The form of payment depends on the country, the fund's rules, and the type of plan.
A pension fund, therefore, is not merely a financial portfolio. It is a structured mechanism designed to convert current contributions into future benefits.
What is the difference between a funded plan and a pay-as-you-go plan?
Defined-contribution retirement plans
In a funded system, contributions are invested to build up financial assets. These assets will then be used to fund future pensions.
Funding is therefore based on an accumulated reserve. Its value fluctuates depending on contributions received, benefits paid, expenses, and the value of investments.
Pay-as-you-go pension system
In a pay-as-you-go system, the contributions paid by the working population during a given year are used primarily to fund the pensions paid to retirees during that same period.
There is not necessarily an individualized portfolio corresponding to each contributor’s entitlements. The system operates on the basis of intergenerational solidarity and the rules established by the plan.
Systems That Can Coexist
Distribution and capitalization are not necessarily mutually exclusive. Many countries combine:
- a mandatory public pay-as-you-go system;
- a funded occupational pension plan;
- an individual retirement savings plan.
In France, mandatory pension plans operate primarily on a pay-as-you-go basis. Supplementary funded pension plans remain complementary. In 2023, they accounted for 5% of total pension contributions and 2.2% of benefits paid, according to the DREES.
What are the different types of pension funds?
Defined-benefit plans
In a defined-benefit plan, also known as a DB plan, the pension amount is determined according to a formula specified by the plan.
This formula may depend on salary, the number of years of service, or an accrual rate.
The employer or the entity administering the plan generally bears a significant portion of the financial risk. If the assets become insufficient to cover the liabilities, additional contributions or corrective measures may be necessary.
Defined-contribution plans
In a defined-contribution plan, also known as a DC plan, the amount of the contributions is fixed, but the final benefit is not.
The amount of capital available at retirement depends, among other things, on:
- contributions paid;
- the capitalization period;
- fees;
- financial performance;
- the terms for converting to an annuity or receiving a lump-sum payout.
The investment risk is therefore borne primarily by the beneficiary. A market downturn as retirement approaches can affect the amount available.
Hybrid Funds
Hybrid plans combine features of defined-benefit and defined-contribution plans. They may include a partial guarantee, a minimum guaranteed return, or a sharing of risk between the employer and the beneficiary.
A public reserve fund differs from an occupational pension fund. It builds up reserves intended to support a public system, without necessarily managing an individual account or entitlement for each worker.
What is a pension fund's coverage ratio?
The ratio of assets to liabilities
For a defined-benefit plan, the funding ratio compares the value of the assets to the present value of the promised pensions:
Coverage ratio = value of assets ÷ value of liabilities × 100
If a fund holds 110 billion euros in assets and has 100 billion euros in liabilities, its coverage ratio is:
110 ÷ 100 × 100 = 110%
A ratio greater than 100% means that the estimated assets exceed the calculated liabilities as of that date. A ratio less than 100% indicates an actuarial deficit.
An indicator that depends on assumptions
The coverage ratio is not a perfectly objective measure. The value of liabilities depends, in particular, on:
- the discount rate;
- the life expectancy of the beneficiaries;
- the retirement age;
- the expected trend in wages;
- the future level of pensions;
- inflation assumptions.
A change in the discount rate can significantly affect the present value of future pensions, even if no immediate payments have been made.
At the end of 2024, the OECD noted significant differences among defined-benefit pension plans. In particular, the aggregate coverage ratio stood at 116.4% in the Netherlands, 123.1% in the United Kingdom, and 74.5% in the United States, based on the scopes of the study.
What is the global size of pension funds?
Assets set aside to fund pensions reached a record $69,800 billion by the end of 2024 within the scope of the OECD’s monitoring, according to its report “Pension Assets Grow to a Record Level in 2024.”
This total included:
- $63,100 billion managed by pension funds;
- 6,700 billion dollars invested in public reserve funds.
These assets had grown by 7.1% in 2024, following an 11.6% increase in 2023. North America accounted for $48,200 billion in assets managed by pension funds, compared with $9,700 billion in Europe.
These figures illustrate the financial weight of pension funds, but an increase in assets does not necessarily mean a proportional increase in individual benefits. It may result from new contributions, market growth, a change in scope, or a combination of these factors.
What role do pension funds play in the markets?
Financing the Economy for the Long Term
Pension funds invest capital over time horizons that can span several decades. In this way, they help finance governments, businesses, real estate, and infrastructure.
Their weight also gives them influence over:
- market liquidity;
- the cost of financing for businesses;
- corporate governance of publicly traded companies;
- voting policies at the general meeting;
- taking environmental and social risks into account.
This influence does not mean that all funds follow the same strategy. Their asset allocation depends on their regulatory requirements, their commitments, and their governance.
Managing Future Commitments
The primary objective of a pension fund is not to pursue returns in and of themselves. It must have the necessary resources to pay the benefits it has committed to.
Asset-liability management involves reconciling:
- financial assets held;
- expected future contributions;
- pensions to be paid;
- their schedule;
- market, interest rate, inflation, and longevity risks.
An investment may offer a high expected return but still be unsuitable if its duration or level of illiquidity does not align with the fund’s needs.
Why do pension funds invest in private equity?
An investment horizon compatible with unlisted assets
Some pension funds have predictable obligations spanning several decades. They can therefore allocate a portion of their portfolio to less liquid investments.
A private equity fund may tie up capital for ten years or more. This time horizon may be compatible with a pension fund’s obligations, provided that it maintains sufficient liquid assets to fund benefits.
A source of diversification
Private equity provides access to unlisted companies with sector, geographic, and operational profiles that differ from those of large publicly traded companies.
However, this diversification remains imperfect. Unlisted companies are exposed to economic cycles, financing conditions, changes in valuation, and the risk of capital loss.
The low frequency of valuations can also reduce observed accounting volatility without reducing actual economic risk.
An allocation subject to liquidity constraints
Private equity investments involve incremental capital calls and distributions, the timing of which remains uncertain.
The pension fund must therefore model:
- uncommitted funds;
- cash flow needs;
- the expected distributions;
- scenarios for reducing the number of releases;
- the cumulative exposure to the various vintages.
An excessive allocation to illiquid assets could undermine the fund's ability to pay pensions during adverse market conditions.
Are there pension funds in France?
A system based primarily on distribution
The French mandatory pension system is primarily based on a pay-as-you-go system. Contributions from the working population fund the pensions paid to retirees in accordance with the rules of the basic and supplemental pension plans.
Supplementary funded pension plans do exist, but they play a less significant role than in some Anglo-Saxon or Northern European countries.
At the end of 2023, French supplemental pension plans had 281.5 billion euros in reserves and assets under management, according to DREES. This amount includes both individual and group plans and therefore does not consist solely of occupational pension funds.
Supplemental Occupational Retirement Plans
The Sapin II Act and the ordinance of April 6, 2017, paved the way for the creation of supplemental occupational pension organizations, or ORPS. In France, these organizations may take the form of supplemental occupational pension funds, or FRPS.
They have been authorized to operate since 2018 under a regulatory framework tailored to occupational retirement plans. In 2023, FRPSs managed 56% of the reserves and assets of France’s supplemental retirement system and collected 45% of the corresponding contributions.
The Pension Reserve Fund
The Pension Reserve Fund (FRR) is sometimes described as a French pension fund. This characterization warrants some clarification.
The FRR is a public reserve fund designed to help finance the pension system. It does not manage individual accounts set up for each employee, nor does it directly pay occupational pensions to its beneficiaries.
As of the end of 2023, the FRR had 21.2 billion euros in reserves, according to the DREES. It therefore falls more into the category of public reserve funds than that of traditional occupational pension funds.
What are the main risks associated with a pension fund?
Market Risk
The value of stocks, bonds, and other investments may decline. A prolonged market downturn may reduce the funding ratio of a defined-benefit plan or decrease the assets of a defined-contribution plan.
Longevity Risk
If beneficiaries live longer than expected, the fund must pay pensions for a longer period than originally assumed.
This risk particularly affects plans that pay out lifetime annuities.
Interest Rate and Inflation Risk
A change in interest rates affects the value of bonds and the present value of future obligations.
Inflation can also increase the cost of pensions when they are adjusted, while reducing the purchasing power of benefits when they are not adjusted sufficiently.
Liquidity Risk
The fund must be able to pay pensions even when the markets are going through a rough patch.
Real estate investments, infrastructure, and private equity can be difficult to divest quickly. Their weight must remain consistent with projected cash outflows.
Governance Risk
Inadequate governance can lead to excessive costs, conflicts of interest, inappropriate risk-taking, or inadequate oversight of managers.
Fiduciary duties generally require those in charge to act in the best interests of the beneficiaries and to document their decisions.
History of Pension Funds
Late 19th century: The development of occupational pension plans
The first employer-sponsored pension plans emerged with industrialization. Some companies introduced benefits designed to retain employees and supplement the still-limited public programs.
After 1945, the expansion of group insurance plans
Growth in salaried employment and the expansion of employee benefits have fueled the rise of corporate pension plans, particularly in the United States, the United Kingdom, the Netherlands, and Canada.
Defined-benefit plans therefore play an important role.
1974: The ERISA Act was enacted in the United States
The ERISA Act establishes standards regarding funding, beneficiary disclosure, and the liability of administrators of U.S. private pension plans.
It represents an important step in the modern regulation of pension funds.
The 1980s and 1990s: The Rise of Defined-Contribution Plans
Defined-contribution plans are gradually becoming more widespread. This trend shifts a larger portion of the financial risk from the employer to the beneficiary.
The OECD continues to observe a decline in the share of defined-benefit plans in several countries.
2017: Creation of the French ORPS framework
The ordinance of April 6, 2017, established organizations in France dedicated to supplemental occupational retirement plans. The FRPS began operating in 2018.
2024: A Record High Worldwide
By the end of 2024, assets set aside to fund pensions reached $69,800 billion across the OECD, surpassing the previous record set in 2021.
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