They are designed to be a long-term investment. This means that money invested in pension funds can be locked away for decades.
To make pension funds an attractive way of saving for retirement, the government offers tax incentives to encourage individuals to invest their cash in pension funds.
People who have a pension fund in place are less likely to become dependent on the state after they leave the workforce.
There are two basic types of pension, known as defined benefit and defined contribution. Defined benefit pensions are most commonly offered by employers as a workplace benefit.
With a defined benefit pension, the amount paid to each employee at retirement is fixed and does not vary with the value of the pension scheme’s assets. The amount paid to each individual is calculated using a formula based around their age at retirement, salary and length of service.
With a defined benefit scheme, the risk lies with the employer as the plan sponsor or the pension company because the scheme must maintain sufficient assets to meet its obligations.
Defined benefit pensions are becoming less common because they have become expensive to operate as life expectancy has increased and interest rates have fallen.
In contrast, a defined contribution pension links individual retirement payments to the value of the contributions made over the years and the interest paid on the investments made by the pension company.
While one person may be comfortable taking a risk with high yielding financial instruments, others may have a better night sleep parking their savings in government bonds. And, if this recession has taught us anything, it’s that every investor is now thinking twice out of fear of investing in junk bonds.