Pension Funds Vs. Mutual Funds

Pension funds are an investment vehicle that has a special focus on retirement. Many people think that pension funds and mutual funds are very similar. This is true to some extent.

Both pension funds and mutual funds allow investors to pool their resources and hire professional fund managers to invest on their behalf. However, the extent of similarity is quite less. Pension funds and mutual funds have a lot of differences as well.

Hence, it would be wrong for investors to assume that they can interchangeably invest in either a pension fund or a mutual fund. There are significant differences between the two funds. It is important for investors to be aware of these differences. The details of these differences have been explained in this article.

1. Lock-In Period: The most important distinction between mutual funds and pension funds is that mutual funds do not have a lock-in period. Even if there is a lock-in period, it is quite less. On the other hand, the money invested in the pension fund is locked in for a long period of time. The money invested in pension funds cannot be withdrawn for long periods of time.

   Generally, very few withdrawals are permitted before retirement. Hence, from an investor’s perspective, mutual funds provide liquidity whereas pension funds do not provide such liquidity. However, if an investor is indeed investing for their retirement, they would not mind the lock-in since it only enforces the financial discipline required to accumulate a significant corpus.

2. Tax Benefit: It is true that investors have to sacrifice liquidity if they invest in a pension fund. However, it is also true that investors obtain several benefits. For instance, there are tax advantages to investing in a pension fund.

   A certain amount of money is exempt from taxes if it is invested in pension funds. Hence, investors can earn a handsome return by simply investing in pension funds instead of mutual funds. Also, capital gains arise when portfolios are rebalanced. For instance, if a person changes their allocation from equity to debt, they might have to sell some shares and realize some profit.

   If the money is invested in mutual funds, the profits are considered to be additional income and are taxed. However, if the same capital gain arises when investing in pension funds, it is exempt from tax. Hence pension funds can be considered to be a more tax-efficient financial vehicle.

3. Expense Ratio: There is a significant difference in the expense ratios of mutual funds as well as the expense ratios of pension funds. This is largely because pension funds have more stable sources of cash inflow and do not see much cash outflow.

   Hence, their transactions are done for the long term. However, this is also because the regulators exert significantly more control over pension funds and they can ensure that the expense ratios are lower. Lower expense ratios can have a significant influence on the final amount which gets accumulated in the corpus fund.

4. Long Term Investments: Pension funds tend to invest for the longer term. This characteristic has a huge impact on return which is ultimately generated by the pension fund. This is because mutual funds are competing for capital in the short run.

   Hence, they have to show high returns in every short-term period. This causes mutual fund managers to undertake more frequent transactions. This generally means that mutual fund managers end up buying the latest fad and then selling it when the market starts to go down.

   Pension funds on the other hand are known to not change their portfolios in the short run. This is because they are not competing for capital in the short run. People are not allowed to divest money from pension funds and even changing the fund is a cumbersome process. This stability allows pension fund investors to have a longer time perspective.

5. Restrictions on Investors: There are no restrictions on investments made in mutual funds. Anyone can invest any amount of money in mutual funds. However, when it comes to pension funds, there are often certain restrictions on investments. These restrictions are in the form of tax savings.

   Tax savings are only given when investments up to a certain amount are made. This is done since pension funds are considered to be a social good and governments want to ensure that the rich do not disproportionately benefit from making investments in pension funds.

6. Restrictions on Withdrawals: As mentioned premature withdrawals are generally not allowed from pension funds. However, even after maturity, there are restrictions on the manner in which pension funds can be withdrawn.

   For instance, in many parts of the world, pension funds will not make a lump sum payment to the retiree. Instead, the payment will be made in the form of an annuity. This is because the purpose of pension funds is to ensure that a person has income during their old age. However, since mutual fund investments are done solely for profit, there is no restriction on withdrawal. Investors can choose to withdraw anytime and there is no compulsion to buy annuities.

7. Regulation: Both mutual funds, as well as pension funds, are regulated financial products. However, the extent of regulation in pension funds is considerably higher compared to mutual funds. This is because if pension funds fail, it may put pressure on social security payments, and hence the governments may be impacted.

   As a result, governments want to ensure that pension funds only invest in carefully vetted financial products. Hence, pension funds face more restrictions when it comes to the type of instrument that they can invest in. Also, pension funds face more stringent reporting requirements.

The bottom line is that pension funds and mutual funds share some basic characteristics. However, these funds are quite different from each other.