Pensions • July 30th, 2020

How Do Pension Funds Work?

Stephanie Faris

Key Takeaways
  • Corporations and government employers sometimes offer pension plans as a perk of employment.
  • Contributions to private pension plans are pooled in a “fund,” which is then invested into low-risk assets that ensure the funds will be there upon retirement
  • Public-sector plans are managed by the governing authority, with legislators building money into the budget each year to cover retirees.

At one time, if you took a job, a pension likely came as part of the deal. But over the years, employers have shifted to plans like 401(k)s, which put a lot of the responsibility on employees to fund. In contrast, pensions are mostly, if not completely, funded by the employer.

While rare, pensions are still in place, both in government and the private sector. With this type of plan, money is pooled in a fund and invested in low-risk assets that reduce the chances the employer will lose money. Then, based on how long you’ve worked for your employer, you can get guaranteed payouts when you retire. Here are some details on how pension funds work.

The Definition of Pension Funds

If you work for an employer that offers a pension, money toward your retirement goes into something known as a pension fund. Looking into how pensions work, you’ll find that pensions aren’t all that different from 401(k)s and IRAs. In this case, though, your employer pools all the money into one fund and invests it.

But how are pensions invested? Obviously, an employer wouldn’t want to lose all the money through a bad investment, so it’s important to choose low-risk assets. If the fund’s growth doesn’t exceed inflation over the years, the employer is still legally on the hook for the pension payout when you retire, so you’ll find most pension funds are invested cautiously.

Defined Benefit Versus Defined Contribution Plans

There are two types of pensions, each with its own unique features. You’ll need to know the difference when looking up how to invest in a pension fund because the answer will depend on the type. Here are the two major types:

  • Defined benefit plan--This is the type of plan people are referring to when they discuss a “pension.” With a defined benefit plan, your benefits are defined from the start, with a promised payout, along with exact qualification terms. In other words, you’ll know when you’re eligible to start taking contributions and how much the employer puts into the fund each month. Defined benefit plans are becoming less common because employers prefer to pass the investment risk to their employees.
  • Defined contribution plan--If you put money into a plan like a 401(k), your retirement plan is a defined contribution plan. With this type of plan, you and your employer both contribute. There’s no guaranteed amount you’ll receive upon retirement. Defined contribution plans are more popular today, and some employers offer both defined contribution and defined benefit plans.

What Are Private Pension Funds?

Now that you know how pensions are funded, it’s time to look at how they’re protected. Unless you’re a government worker, your pension is funded privately, with your employer pooling the money and setting it aside for your eventual retirement. As you can imagine, private-sector employees aren’t given the freedom to manage these funds however they want. They’re regulated under private sector law.

Regulation is an important part of how pension funds work. In the U.S., private pension funds are regulated by the Employee Retirement Income Security Act of 1974 (ERISA), which sets standards for employers providing these pensions. Those standards include setting participation guidelines and regularly disclosing those guidelines to all participants.

What Are Public Pension Funds?

Those who work in the public sector--including federal and local government employees, teachers, and law enforcement officers--have pensions regulated by the government. The government regulates these pensions, managing the funds as laid out by the governing legislature.

Politicians are responsible for ensuring employee pensions are covered, which means setting money aside in each budget to cover the employees retiring that year. Unfortunately, these plans are often underfunded, which has led some states to shift to defined contribution plans, where employees contribute to the plan and monitor growth through retirement accounts like 401(k)s or IRAs.

Regulations Governing Pension Funds

As you’re outlining your pension investment strategy, you likely want the confidence of knowing your funds will be there for you when you someday retire. Private pensions are regulated by ERISA, with the Department of Labor’s Employee Benefits Security Administration responsible for ensuring regulations are followed. Under ERISA, not only does the employer have to follow regulations in ensuring the funds are protected, but the person administering the plan has to meet certain criteria, as well.

In addition to ERISA, the Pension Benefit Guaranty Corporation (PBGC) also protects future retirees who are paying into pensions. One of the biggest benefits PBGC provides is a pension search directory, which helps you locate missing pensions. You can also contact PBGC once you’ve tracked down a missing pension and they’ll guide you through the process of getting your money.

Traditional Investing Versus Alternative Investments

Although pension fund investment rules work to ensure the funds are protected, plan administrators do have a choice in how they invest the funds. The traditional investment strategy associated with pensions divides assets between multiple types of investments. Those can include bonds and equity investments.

In recent years, pension investment options have expanded to loop in some alternative investment types. Those can include private equity, hedge funds, and high-yield bonds. However plan administrators invest the funds, experts advise keeping those investments as diverse as possible. By splitting the money across multiple asset types, employers can minimize risk and protect the employees who trust them.

Bottom Line

If you’ve worked for an employer that offers a retirement plan, you may not have stopped to think how a pension fund acts as an investor. But your plan administrator is working hard in the background to make sure your money is there for you when you retire.

Have questions about how your pension plans fit into your retirement? Sit down with an expert financial advisor from Retirable today to get advice customized to your needs.

Author

Stephanie Faris

Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a writer for a credit card processing service and has written about finance for numerous marketing firms and entrepreneurs. Her work has appeared on Money Under 30, The Motley Fool, MoneyGeek, E-commerce Insiders, and GoBankingRates.