Pension Plans
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Pension Plans
Introduction
The members who invest in the assets of defined contribution superannuation funds seek a certain level of choice in their investments (APRA, 2005). There has been a considerable shift in the pension plans for the past 20 years. The number of employees who took the pension plans in 1975 was 39% for the defined benefit plan and 14% by the defined contribution plan. Now a days, the workers have become more active in managing the retirement plans. Any investor who is investing in the pension plan has to balance the security, affordability and adequacy aspects. The problem with these three objectives is that they all are not achievable at the same time. Two of these objectives are achievable at the expense of the third. This document will provide the definitions of the two options available to people namely the defined benefit and defined contribution plan. The differences between the two plans will be discussed in detail and the last part will show what factors affect them while deciding on the choice.
Defined Contribution Plan
The contribution plan is the one in which an account is opened in the name of the employee and employer makes some contributions in that account. If the account requires contribution from the employee as well then the employee will also contribute certain amount of money to the same account. The benefits depend upon the aggregate earnings that are accumulated and the investment returns that are available on the accumulated amount. Sometimes the employees have the choice regarding the assets in which the investment will be made. The employee can know the total amount available at any time. These plans are actually accounts that have tax deferred savings and are fully funded. These funds are not covered by Pension Benefit Guarantee Corporation insurance.
In a defined benefit plan, the planning for the pension aspects include a formula that takes into account the length of service with the current employer as well as the salary or wage. Many of these plans also consider the social security benefits that the employee is entitled CITATION Zvi88 \l 1033 (Zvi Bodie, 1988).
There are certain differences in the two plans that are available to the people. These differences pertain to the risks that the employees and employers face, the impact of the rising prices on these investments and the importance of governmental supervision.
The conceptual framework that governs the defined contribution plan for pension is simpler as compared to the defined benefits plan. The employer makes some regular payments in the account designated for the pension funds. This amount is generally fixed as some percentage or portion of salary. This percentage or proportion does not need to be constant over the whole tenure of the job. The contributions made by both employer and the employee are tax deductible in case of the defined contribution plan. Similarly the income that accumulates as a result of investment is also tax free. Most options limit the investment to certain types of bonds, stocks and money-market funds. There are certain options that the employees have at the time of maturity of the amount. The employee can either take a lump sum or an annuity when he retires. The size of the annuity depends upon the total amount that has been accumulated in the account. The risks associate with the investments are borne by the employee himself. The employer has no obligation beyond the payment made by him in the account.
The valuation formula for the defined contribution plan is not complex at all. This is measured in terms of the market value of the assets held in the investment options. The employees are given certain options through which the annuity for the life after retirement can be purchased at the present time with the accumulation in the account. The actual payment in terms of annuity will depend upon the total amount available in the retirement account, the interest rate at the time of retirement and the actual wages that the employee gets over the period of employment.
Annuities save the employees from the risks associated with longevity, a pure defined contribution scheme leaves the employee with many kinds of risks. These risks are discussed later in the study. The modification in the pure case is done to divide the risks on a broad base CITATION Zvi88 \l 1033 (Zvi Bodie, 1988).
Defined Benefits plan
As discussed above, the defined contribution type of the pension plan focuses on the market value of assets that are currently backing a retirement account. The defined benefits account focuses on the flow of benefits which will be received by the individual on retirement. The two major factors that are considered while ascertaining the benefits for the employee are the length of service and wage history of the employee. We can consider a plan as an example where an employee receives 1% of his last salary multiplied by the number of years that he has worked for the company. The worker will retire at the age of 65 and there is no option of early retirement for the employee. The expected life for the employee is 80 years. This is a form of deferred annuity because the employee will not be getting the first payment of the annuity before he gets retired. This is also a form of nominal payment because the amount payable to the employee by the employer is fixed at any point in time including the retirement age.
If the interest rate and wage profile are given, the present value of the accrued benefits for the defined benefits plan can be calculated easily. The factors affecting the value in this scenario are the number of years in the job and the wage itself. The interest rate increase will benefit the employee when he is nearing the end of the pension plan. In the following lines, we will discuss the effect of inflation on the payments of annuity that will be received CITATION EDw05 \l 1033 (Whitehouse, 2005).
Effect of Inflation and time value of money
The inflation is assumed to be 7% and the change in the value of pension benefits will be observed over a period of one year. At the start of this year, the worker had an accrued annuity value of 1500 per year beginning at age 65. Applying the interest rate of 10 % we can calculate the present value of this deferred annuity as $ 660. We will assess the increase in the pension benefits for this person by breaking them into three parts. The employee has had one additional year of service with the employer, so we can see that the inflation adjusted salary for the employee will be $ 16050. On this amount the employee will earn $ 160.5 for one year @ 10%. The second aspect is the increase in salary of the employee of $ 1050 that will give the employee $ 105 per year. The total benefit for the employee is $ 265.50 which will have a present value of $ 127 at the end of the year. The last factor will be the increase in the previously accumulated amount by 10%. This will go from $ 654 to $ 719.4 because the maturity date has come closer by one year. There is considerable difference between the amount of money that is available at 0% inflation to the employee and at 7 % inflation. The salary is constant in case of the no inflation scenario which shows that the employee will only earn the amount on the beginning amount of salary for the year. The employee will earn an additional $ 150 per year for the rest of his employed life. The additional benefit that the employee will get will increase as the retirement comes near. This also shows that the constant amount that is earn per year by the employee will have a higher present value as the time to maturity approaches. The system of the defined benefit pension plan has a characteristic of back loading. This effect is much stronger when we consider the inflation rate of 7% to be effective. This is because the inflation will also affect the interest rate prevailing in the system. The basic point is that the difference between the percentage of salary at year 30 and 65 is 5 % when there is 0 % inflation. When there is an assumption of 7% inflation, the difference between the salary percentage at year 30 and year 65 rises to 18%. The pensions in the defined contribution plan are independent of inflation and interest rates. The choice of appropriate contribution rates allow the employer to achieve any pattern of back loading.
Funding
The plans under the defined contribution are fully funded by default. This means that the liability of the employers is restricted to the market value of the assets that have been included in the plan. The defined benefit plan for the pensions has a complex calculation for the funding aspects. There is also much controversy involved in the funding aspects of the defined benefit plan. It is easy to calculate the value of assets in which the investments have been made especially if these securities are traded openly. The problem lies in the calculation of liability of employer. If we talk about the legal aspects, the liability of the employer is restricted to the present value of assets that has to be paid if the contracts end immediately. Some of the researchers argue that the liability of the employer should also contain the future salary growth of the employee. This ambiguity in the calculation of employer’s liability makes it unclear whether the nominal or real interest rate must be used in finding out the present value of the benefits. One solution to this problem is suggested by using immunized or dedicated portfolio of the bonds using current market prices. Although this method is clearly superior to the simple interest rate assumption, this method only provides an estimate because dates on which the pension liabilities are paid off are very far away from the original maturity dates. The exact bond valuation scheme is not feasible to be used.
Risks Associated
The biggest risks that are involved with the pension plans are the shocks on the macroeconomic levels that can affect output. Prices or both. The shocks can also be demographic in nature which can affect the market prices, quantities and pension claims. The political aspects affect the pension schemes because all the schemes depend upon the effective government. This dependence is shown in different ways under different pension plans. The management risk through the incompetence as well as fraud. The information with the consumers is not complete so they will not be able to judge the fraud element properly. The investments made with the funds of investments from pension funds are prone to be affected by the market fluctuations. The value of annuities that will be paid to the employee depends upon the number of years left in the service and interest rate that insurance company expects to earn on these funds. This is also a form of investment risk. CITATION Nic06 \l 1033 (Barr & Diamond, 2006)
0000The above diagram shows the comparison of expected and actual returns for the pensioners over a period of 15 years. As we can see that around the year 2008 where the financial crisis hit the whole world, the actual returns fell sharply, otherwise both the rates moved along the same lines.
The above graph shows a comparison of returns offered by the defined benefit plan and defined contribution plan. We can see that the defined contribution plan has shown consistent rise in the return while there is a fall in the return of defined benefit plan. The reason for this may be that the employees are allowed to choose the assets in which they can invest in case of the defined contribution plan and their choice keeps the rate of return a priority. The assets in which the amount is invested in case of defined benefit plan are predefined.
References
BIBLIOGRAPHY Barr, N. & Diamond, P., 2006. The economics of pensions. LSE Research Online, 22(1), pp. 15-39.
Erik Hernaes, J. P., 2011. Occupational pensions, tenure, and taxes. Journal of Pension Economics and Finance, 10(3), pp. 435-456.
Poterba, J., Rauh, J., venti, S. & Venti, D., 2007. Defined Contribution plans,defined benefit plans and the accumulation of retirement wealth. Journal of Public Economics, Volume 91, pp. 2062-2086.
Whitehouse, E., 2005. The tax treatment of funded pensions, s.l.: s.n.
Zvi Bodie, A. J. M. a. R. C. M., 1988. Defined Benefit versus Defined contribution pension plans: What are the Real trade offs?. In: Pensions in the US economy. Chicago: University of Chicago press, pp. 139-162.
