MANY savers believe that their pension contributions (as well as those made on their behalf by their employers), or some multiple thereof, will be returned to them during their retirement. However, as we illustrated last week, devaluation and inflation erode the value of money over time.

Furthermore, the performance of the assets within your pension fund will determine the amount of funds you have available to you during retirement.

This simple fact often goes unnoticed and few people try to understand what happens to their money after it is deducted from their pay cheque. What are the assets in your pension portfolio earning? Is the rate of return above devaluation and inflation? Even if the return is positive, is it sufficiently high to compensate for the risk of the investments in the portfolio?

While one would hardly expect the average contributor or trustee to be able to run complex portfolio analyses and simulations, there are certain basic principles that must be understood by everyone. For starters, what do pension funds invest in? Today we will look at a very simplistic theoretical review of different assets classes available to pension funds and why they are important.

Bonds

Bonds are effectively a type of loan to a government or a company. The issuer of the bond pays interest at a pre-determined rate and frequency. The issuer is also responsible for repaying principal in full at a specific date.

Bonds provide investors with a steady flow of income and are thought to be “safer” than equities because your principal is protected.

Additionally, in the event of bankruptcy/default, creditors and bondholders are usually paid out before stockholders.

However, bonds can be traded like equities. Their prices can go up or down, and investors can buy or sell them at any point during their tenor. In other words, one does not have to hold a bond until maturity. Rather, the bond can be traded like any other asset and bondholders may also realise capital gains. For example, back in 2013, a 2025 Sacramento County Municipal bond was trading at around 102 US cents on the US dollar. However, in 2015, that same bond is trading in excess of 118 US cents.

Pension funds need bonds in their portfolio in order to generate income that will service the needs of the beneficiaries on an ongoing basis.

Stocks

Stocks or shares represent the legal vehicle through which you effect ownership of a company.

Stocks are thought to be riskier than bonds for a variety of reasons; chief among them is the fact that the principal of your investment is not guaranteed. However, in exchange for the higher risk profile, equities historically provide higher rates of growth to investors.

Equity holders realise the full upside of the increase in book value or stock price associated with the stock. For example, some Facebook stockholders would have bought into the company at US$38 per stock; today the price is just under US$80 per stock.

Equities are important for pension funds so that they can more aggressively increase the value of their portfolios over time.

Beneficiaries are living longer and the needs of the pension plans are growing. This increases the rate of growth that is needed to keep a plan funded.

The key lesson to learn here is that there are many different asset classes. A well-diversified portfolio allocates funds across the different asset classes based on the risk profile of the investor or the investment needs of the beneficiaries.

Due to the size and purpose of pension funds, these portfolios must spread their resources across all asset classes to maximise growth and risk-adjusted returns.

Next week, we will look at real estate and private equity as important asset classes for pension funds.

Marian Ross is AVP business development at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm