Pension funds invest billions on our behalf, and data1 shows that most of us are happy to let them get on with it. However, if you’ve ever wondered what’s in yours, here are 10 things a pension fund invests in.
Quick note: every pension fund has its own investment policy. The list below goes from the most commonly held investments down; with the most exotic ones at the end.
#1 Equities (company shares)
When an investor buys an equity they are taking a stake in a company and receive a share of the company’s profits in return (dividends).
The investor hopes the company will become more valuable over time, as then their shares should also become more valuable. They also hope that the company becomes more profitable, as then the dividends should grow.
Of course, profits may not materialise or the company could go out of business altogether. Equity returns are therefore unpredictable and can be very volatile.
However, investing in equities over the long-term has usually proved to be a good strategy compared to many other types of investment; investors have usually been rewarded for living with the higher volatility of equities.
A pension fund’s equity portfolio will contain the shares of hundreds of different companies, in different parts of the economy and from different countries. Therefore, the portfolio may also be subdivided into smaller sub-portfolios grouped by:
- Size. For example, small, medium or large companies.
- Country or region. For example, European, US, or UK equities. Or developed markets and emerging markets.
- Sector. For example, technology, healthcare or financial companies.
- Style. For example, “value shares” (shares that appear to be cheap compared to the company’s fundamentals) and “growth shares” (shares of companies expected to grow quickly compared to the market as a whole).
#2 Cash
This can mean traditional cash held in a bank account or a more strategic investment in a money market fund. Money market funds contain traditional cash and very short-term lending to very creditworthy companies or governments.
Cash’s key feature is that it can be accessed very quickly – it is the most “liquid” type of investment.
The value of cash is also very stable. This means that investors do not need to be too concerned about selling cash at the wrong time, unlike, say, equities.
These security features mean that the long-term returns on cash have been lower than other investments’ returns, with UK cash returns tracking the Bank of England’s base rate.
#3 Government bonds
A bond is a type of loan. Investors lend money to a government or company for a fixed period in return for interest payments known as coupons. In the UK, government bonds are known as gilts. We explored these in detail in this post.
#4 Corporate bonds
Companies are usually thought to be less creditworthy than governments. Therefore, corporate bonds usually pay a higher interest rate than government bonds. The difference is known as the spread – the less creditworthy the company, the higher the spread.
Larger borrowers will have a credit rating assigned to them by an independent credit rating agency such as Moody’s or S&P. The higher the credit rating, the lower the chance of default and the lower the spread.
S&P credit ratings and historic default rates (i.e. the percentage of companies that defaulted) are given as examples below.
Credit ratings and historic default rates2
| Credit Rating | Average annual default rate | Highest default rate (year in brackets) |
| AAA | <0.01% | <0.01% (2008) |
| AA | 0.01% | 0.38% (2008) |
| A | 0.05% | 0.38% (2008) |
| BBB | 0.18% | 1.00% (2002) |
| BB | 0.80% | 4.24% (1982) |
| B | 3.95% | 13.84% (1991) |
| CCC/C | 24.45% | 49.46% (2009) |
Companies with higher credit ratings (BBB or higher in the table above) are known as investment grade. As one would expect, default rates have been highest during economic downturns, such as 2008/2009 (the credit crisis and subsequent recession).
When a company defaults, corporate bond investors usually won’t lose all their money. This is because bondholders are one of the first to be repaid when a company is wound up. The amount they get back is called the recovery rate.
#5 Real estate
Pension funds tend to invest in offices, factories and shops, rather than houses and flats3.
Most pension funds will own real estate using a pooled fund. This enables them to diversify more easily, as each unit of the pooled fund contains a small proportion of lots of different properties. The very largest pension funds may own individual properties directly.
Real estate returns depend on the rents paid by occupiers and the change in value of the properties.
Rents are covered by a contract with the occupier and are usually inflation-linked. This usually makes rents more reliable than equity dividends; however, rents do depend on the ability of the occupier to continue to pay.
Occupiers renew their rental agreements periodically, so rental returns also depend on how desirable the property is as a place to work, manufacture, sell etc. Property managers will often try to make their properties more desirable by renovating them, gaining planning consents or, sometimes, changing how their properties are used altogether.
Real estate is expensive and time consuming to buy and sell. The cost can often be several percent. Therefore, real estate is very much a long-term investment.
Pooled funds can make real estate easier to buy and sell. However this relies on there being a ready supply of buyers and sellers. Sometimes, real estate pooled funds can become very illiquid, making it extremely expensive or even impossible for investors to sell their units.
We saw this post pandemic. Some real estate funds with high allocations to offices became much less liquid and locked up investors’ cash for several quarters or longer.
#6 High yield bonds
These are bonds of companies with lower credit ratings (BB or lower in the table above). They pay a higher interest rate than investment grade bonds due to having a higher risk of default.
The price of these bonds tends to be more sensitive to the economic environment. As such, they perform more like equities than investment grade corporate bonds do.
#7 Private equity / venture capital / private debt
Private equity refers to taking a share of a company through a private transaction, rather than through a publicly traded stock market. Venture capital is a type of private equity that invests in early-stage companies, with the hope of very high returns as the company grows.
Most institutions will access private equity via funds, which will, in turn, invest in several different companies.
The returns of a private equity fund often look like a “j-curve” – negative in early years before turning positive. This is because the fund will usually invest significant amounts early on acquiring companies or turning companies around, and companies can take several years to come good.
Private debt – also known as private credit – is when investment managers, pension funds and other institutions lend directly to borrowers. Unlike traditional corporate bonds, these loans are arranged privately, rather than through a publicly traded market.
The terms of each loan will be negotiated individually, based on the requirements of both the borrower and the lender.
#8 Hedge funds
A hedge fund uses various trading strategies to make a profit. The main driver of returns will be the skill of the hedge fund manager.
Fees on hedge funds tend to be higher than other investments – a typical structure is 2% of the amount invested, plus 20% of the returns of the fund over a certain hurdle.
Some pension funds choose to invest in a “fund of hedge funds”, which contains multiple hedge funds for diversification.
#9 Infrastructure
Pension funds may invest in large infrastructure projects such as roads, bridges or renewable energy projects. In return, they will receive a share of the revenue generated by the project (for example the tolls of a bridge).
Infrastructure investments are usually made via funds, enabling pension funds to access several different projects. These projects can take many years to be complete, so infrastructure is a very long-term investment – often more than 10 years.
In the last few years, both the Conservative government and the Labour government have tried to find ways to encourage UK pension funds to invest in infrastructure to help support the UK economy.
#10 Catastrophe bonds
Owning a catastrophe bonds is like providing insurance. A catastrophe bond pays interest like an ordinary bond. However, if some pre-specified insured event happens (e.g. a hurricane), the bond issuer will retain some of the investment to cover their losses.
Catastrophe bonds have become increasingly popular with pension funds, as catastrophe bonds perform very differently to other investments. This is because their returns depend on things like the weather, rather than, say, the economy.
- For example, according to the PPI 90% of those enrolled in master trust/multi-employer defined contribution pension funds remain in the default investment strategy. ↩︎
- Source: S&P Global Ratings Credit Research & Insights. Covers period 1981 to 2023. ↩︎
- There may be some large residential developments in specialist real estate portfolios. ↩︎
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