Why Pensions Own So Many Stocks

Why Pensions Own So Many Stocks

Pension funds typically own a significant amount of their assets in stocks, or shares of companies, given their high overall growth rate and ability to earn higher returns. If you have a workplace pension and have never changed the default investment option, somewhere between 60% and 90% of your money is almost certainly in equities right now. That is a deliberate choice, and it is worth understanding why.

Why equities at all

The short answer is returns. Over the long run, owning shares in companies has produced meaningfully higher returns than lending money to governments or companies through bonds, and significantly higher returns than holding cash.

The long run numbers vary depending on the exact period and index, but a broad global equity portfolio has historically returned somewhere in the region of 7 to 10% per year on average before fees. Government bonds have typically returned 3 to 5%. Cash has barely kept pace with inflation.

Over a single year, that difference might not feel like much. Over a 30 or 40 year pension saving period, it is transformative. A pension pot growing at 7% per year will roughly double every 10 years. The same pot growing at 3% will take over 23 years to double. Compounding at even a modestly higher rate over decades is the single biggest driver of how large your pension ends up being.

This is why pension funds in the growth stage are so heavily weighted towards equities. The job of your pension at that point is to grow as much as possible, and equities are the asset class with the strongest long run track record for doing that.

But why so many stocks?

This is the question most people get to once they understand the case for equities. Why not just back 50, 40 or even just 3 to 5 companies instead of the hundreds or even thousands of stocks that most funds hold? Surely it is easier to get to know a handful of companies really well than trying to second or third guess the prospects for hundreds.

The main reason is one word: diversification.

Even the best investment manager in the world does not get it right every time, and by owning a handful of stocks you are effectively putting all your eggs in one basket. Some ideas might work, but by backing only a handful of companies you risk one bad manager, idea or stroke of luck destroying your wealth.

There will always be a stock, an idea, or a "tip" that beats owning thousands of smaller shares of lots of companies. The chance of you finding that stock consistently however is almost zero.

Buying a diversified portfolio of stocks therefore gives you exposure to lots of companies, of which some will fail and some will go up 10 or 20 times in value. But critically your pension is not tied to one idea, but rather thousands of ideas at the same time.

To put it another way: if you own 2,000 stocks and one of them goes to zero, you have lost 0.05% of your portfolio. Annoying, but irrelevant. If you own 5 stocks and one goes to zero, you have lost 20%. That is the kind of loss that takes years to recover from, if you recover at all.

How pension funds actually do this

In practice, most pension funds achieve this diversification through index funds, also called tracker funds or passive funds. An index fund does not try to pick winners. It simply buys every stock in a given index, such as the FTSE All-Share (which covers the UK market) or the MSCI World (which covers developed markets globally), in proportion to each company's size.

This approach has two major advantages. First, it gives you instant diversification across hundreds or thousands of companies in one fund. Second, it is cheap. Because nobody is being paid to research individual stocks and make active bets, the fees on index funds are very low, often 0.1% to 0.2% per year.

The alternative is active management, where a fund manager picks the stocks they believe will outperform the market. Active funds charge higher fees, typically 0.5% to 1.0% or more, on the basis that the manager's skill will more than offset the additional cost.

The evidence on whether active managers consistently deliver on that promise is not encouraging. Study after study over decades has shown that the majority of active managers underperform their benchmark index after fees over the long run. Some outperform in any given year, but identifying in advance which ones will do so next year is extremely difficult. This is why most workplace pension default funds are built around passive or predominantly passive strategies.

If you have a SIPP or personal pension and are choosing your own funds, the same logic applies. A low cost global equity tracker gives you diversification across thousands of companies in dozens of countries for a fraction of the cost of an actively managed fund.

When diversification feels like it is not working

There is one scenario where diversification disappoints, and it is worth being honest about it. In a broad market sell-off, such as the financial crisis of 2008 or the initial COVID shock in early 2020, almost everything falls together. Owning 2,000 stocks instead of 5 does not help much when the entire market drops 30%.

This is unsettling when it happens. It is also normal, and it is temporary. In both of those examples, markets recovered their losses within a few years. For someone with decades of pension saving ahead of them, a broad market fall is not a disaster. It is a period where your regular contributions are buying more shares at lower prices, which benefits you when the recovery comes.

The risk is different if you are close to retirement. A 30% fall in the final year before you stop working is a genuine problem if most of your pension is still in equities. This is exactly why pension funds use a glide path to gradually move out of equities and into bonds and cash as your retirement date approaches. Diversification protects you from individual company risk. The glide path protects you from market timing risk.

What this means for you

If your pension owns hundreds or thousands of stocks, that is not a sign of indecision. It is a deliberate strategy to capture the long run growth of global companies while making sure no single company can do serious damage to your savings.

The combination of equities for growth, diversification to manage risk, and low cost index funds to keep fees down is not exciting. It will never be the subject of a dinner party conversation. But it is the approach that has consistently produced the best outcomes for the largest number of pension savers over the longest periods of time, and there is a reason it is the default.

---

Key takeaway: Pension funds own lots of stocks because equities offer the highest long run returns, and they own thousands of them because diversification means no single company can wreck your retirement savings. Most pension funds achieve this through low cost index funds, which is a sensible default for the majority of savers.

---

Frequently asked questions

Why do pension funds invest in stocks instead of keeping money in cash?

Over the long run, company shares have historically delivered significantly higher returns than cash or bonds. Because pension saving spans decades, the higher growth from equities is what builds your pot to a size that can actually fund a retirement. Cash feels safe but loses purchasing power to inflation over time.

Why do pension funds own thousands of stocks instead of just a few good ones?

Diversification. Even the best investment managers do not get every pick right, and owning only a handful of companies means one bad outcome can destroy a significant portion of your wealth. Owning thousands of stocks spreads that risk so that no single company can do serious damage to your pension.

What is the difference between an active and a passive pension fund?

A passive fund, also called a tracker or index fund, buys every stock in a particular index and aims to match the market return at very low cost. An active fund employs managers to pick stocks they believe will outperform. Most workplace pension default funds use passive or mostly passive strategies because the evidence shows that most active managers do not consistently beat the market after fees.

Should I be worried when the stock market falls and my pension goes down?

Short term falls are a normal part of equity investing. If you are decades from retirement, a market fall can actually work in your favour because your ongoing contributions buy more shares at lower prices. The concern is only relevant if you are very close to retirement and still heavily invested in equities, which is why most pension funds gradually reduce their equity holdings as you approach your target retirement date.