Why Pension Funds Should Not be Allowed to Invest in Equity?

Traditionally, pension funds were averse to equity investments. However, over the years, pension funds have been steadily pouring money into pension funds. This has been facilitated by the lower interest rates offered on fixed income securities as well as the rise in the value of stocks and other risky assets.

Nowadays, most experts believe that it is beneficial for pension funds to continue to invest in equity.

However, there is still a small faction of experts who believe that investing in stocks is against the interest of pensioners. In this article, we will present the case against investing in stocks.

1. Over Exposure to Equity Markets: People who believe that pension funds should not invest in stocks, think that if an individual wants to add stocks to their overall portfolio, they can do so themselves. However, if a pension fund adds stocks to its portfolio, it ends up creating an over-exposure to equity-based risks. This is because of the fact that the factors which govern risk in the equity market are pretty much the same factors that govern their incomes from jobs.

   Therefore, if the stock market were to go down, the pensioners risk losing their jobs as well as their assets accrued within the pension funds. This is against the principles of diversifying risks and hence pension funds must avoid making investments in equity.

2. Lower Chance of Default: Debt investments have a much lower chance of default as compared to equity investments. If pension funds invest in equity, there is a chance that the defined benefit payout may be low if the stock market collapses.

   However, most of the debt instruments that the pension funds invest in are vetted first. Hence, they are not likely to default and can be considered to be risk-free particularly if they have been issued by the government or government agencies.

3. Intragenerational Risk Transfer: Stock market values are determined by discounting the future cash flows in order to determine the present values of these earnings. Hence, the values offered by the market today are the values that will actually materialize over the next few years if the stockholder continues to bear the risk.

   In a way, stock markets enable the transfer of risks across many years. This is generally not a problem for an individual investor. However, this can be a problem for a pension fund. This is because, in a pension fund, the people who reap the benefits may not be the same as the people who bear the risks.

   It is quite possible that a retiree may be able to obtain a higher value because they have to bear no risk but can gain from the rewards.

   At the same time, the young pensioner may end up bearing the risk for a long time without even being compensated for the same. This means that equities end up creating intragenerational transfers of risk which are involuntary. This creates a problem for pension funds as they end up favoring one set of retirees over the others.

4. Wastage of Tax Shield: Pension funds have a very advantageous tax shield. The investments in pension funds are generally allowed to grow tax-free. Now, when it comes to equity investments, they are also allowed to grow tax-free anyways! However, debt instruments are taxed if they are not within a pension fund.

   Hence, many experts believe that pension funds are very tax-efficient when it comes to managing debt instruments. As a result, if a person wants to have a portfolio that contains both debts as well as equity, they should use pension funds to hold the debt portion of their investment.

   At the same time, they can use their equity investments in their personal account. Using pension funds to hold equities is just a waste of the tax efficiency which is built into their structure.

5. Higher Transactional Costs: When a pension fund buys a debt instrument, they generally intend to hold it till maturity. Also, they tend to buy directly from the issuing company. Hence, the transaction costs are negligible in such cases.

   However, when it comes to equities, the pension funds have to keep churning their portfolios. This is because the performance of equities is unpredictable and the fund managers need to make constant adjustments to their portfolios.

   Also, such a portfolio cannot be passively managed since an active fund manager is required in order to maintain this portfolio. The end result is that the transaction charges of equity-based portfolios are much higher as compared to debt-based pension portfolios. The compounding effect of many years makes this difference even more significant.

6. Unpredictable Cash Flow: Last but not the least, debt-based pension funds are very stable. It is very easy for pensioners to estimate their future earnings. On the other hand, equities can be very volatile.

   It is possible that the equity markets may collapse 20% to 30% in any given year. For a pensioner, the 20% to 30% fall can be catastrophic since they will not get a chance to recover from the same.

Hence, it can be said that there are several reasons that pension funds should not be allowed to invest in equities. If any person does believe that these reasons are applicable to them, they can choose not to invest in equities as per the defined contribution pension plan structure.