Corporate Financial Management
What do you think are the important factors that should be considered by tertiary sector employees when they are deciding whether to place their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan? What issues relating to the concept of the time value of money, taxes etc., might be important in this decision-making process? Explain.
Under the superannuation policy, employees are encouraged to invest and save for the future and specifically their year of retirement by making minimum contributions to superannuation investments hence complying with the superannuation or retirement funds requirements. Employers are also mandated to make contributions to these superannuation investments on behalf of their employees. These allocations made are derived from a percentage of their income. This superannuation policy initiative helps in reducing the burden associated with the social security system by providing payments for a pension to care for individuals during their stage of the retirement of their lives. On the other hand, it also helps employees to successfully invest the amount that they contribute to providing enough income for funding those that are close to the employees such as their relatives and friends.
As a result, employees currently have a higher option in deciding on the types of assets as well as funds that they are contributing to the superannuation should be invested in the scheme. On this basis, the employees remain with two forms of schemes that they have to make a selection of, which include an investment choice plan and DB plan.
An employer’s pension program can be variedly classified into two broad types which can be an investment choice pension plan (IC) and DB pension plan. The investment choice pension plan restricts each and every employee creates an account where both the employee and the employer make continuous contributions. The accruing benefits are dependent upon the contributed funds as well as investment earnings that are accumulated in the statement. Most of the time an employee has to make a different choice concerning the type of assets where the collected funds will be invested in. The employees always have to determine every time the value of the amount spent in the superannuation funds. Investment choice pension is a savings account in trust with the tax-deferred for all the employees who are fully funded (Chaudhry, Yong and Veld 2017).
In DB plan, the pension benefit that the employees are entitled to can be calculated using a formula which considers the employee’s year of service, as well as salary or wages.
Defined Benefit Plan versus Investment Choice Pension Plans
DB and IC plans possess different characteristics concerning the risks that the employees and employers, the funding flexibility, the sensitivity of importance to inflation, and the significance of supervision by the government (Kriz and Chen 2017).
Under this scheme, the employer, as well as the employee, makes continuous contributions to the pension retirement account of the employees. The total amounts of money contributed by the employees are always put as a predetermined fraction of the salary of the employees through the value provided is not constant over the period (Charlton and McKinnon 2018).
Contributions from both the employer and employee are not tax-free, while investment income accrues are not tax-deductible. Employees have to choose their own as to how the investment will take place in their accounts. The principle allows the amount of money contributed for investment to be invested in security, even though in practice most schemes restrict investment options to be in the form of stock, bond, as well as the funds of the money-market. The employees who have retired from work will either obtain annuity or lump sum, the size of each is based on the number of funds that are in the retirement account. Employees will, therefore, endure all risks that are associated with the investment; the consideration for retirement is by description fully funded; therefore, the Company has no responsibility but only to make a periodic contribution (Bithas, Latinopoulos, Kolimenakis and Richardson 2018).
IC plan Valuation involves measuring the assets market value held in the account for the retirement of the employees. Nevertheless, as an advisor for individual financial planning, the sponsor of IC plan sponsor often offers employees with the specified size of a life pension beginning at the age of retirement that can be bought now with the funds that are in their account under different circumstances. The exact size of the annuity for retirement will entirely be based on the realized retirement’ interest rates, the performance of investment of the retirement funds, and employees’ wage path (Landon and Smith 2018).
DB Plan
DB scheme emphases on the benefits’ flow that a person will obtain upon retirement, while IC scheme emphases on the assets value currently invest at retirement account. A classic Defined Based plan should find out the benefits of the employees as a function of the total years of wage history and service (Paradi, Sherman and Tam 2018).
The current value of accrued liabilities might increase as the service continued because of the factors stated below:
- When the year of service increase, DB will also increase
- When the wage increases, the retirement benefit will also increase
- As time elapses, the time remain less until the retirement benefits start, hence, their PV increases at the IR
Investment Choice Pension Plan
Investment Choice and Performance
The common cause of risk to various employees that are in IC plan is the performance of funds that are invested. Nevertheless, the purpose of this risk can be reduced. For instance, the constant amount taken to the IC scheme could spend for the acquisition of deferred annuities which later on would produce income streams for retirement which are similar to those that Defined benefit plan provides. On the other hand, it is possible for the program to choose the strategy for investment that has got low variance rates of returns. Many researchers suggest that the addition of commodity future to portfolios can offer adequate protection against inflation successfully. So, in either real or nominal terms, IC scheme do not unavoidably enforce the participant’s substantial risk, given the existence of the strategies of low-variance investment (Glaum, Keller and Street 2018).
IC plan provides enough flexibility of choosing a risk-return strategy appropriate for the preferences and circumstances of the employees typically. Whereas, Defined Benefit plan necessitate people to accumulate a portion of the retirement saving as deferred life annuities as well as limiting the choice of risk-return (Vercellini, Frattaruolo and Buggio 2018).
Determining factors
Accrual Patterns- DB plans are intrinsically back loaded. IC scheme can also be back loaded by selecting rate of the contribution that rises due to a worker’s tenure and age; therefore, the difference in inherent in the pattern of accrual between the designs of the two plan is that the back loading of Defined Benefit is stochastic in a way that the benefit accruals is based on the wage inflation rate. This source of uncertainty is avoidable with both the employee and employer may benefit from shedding. Basing the argument on this outcome, IC scheme seems to be superior as compared to DB scheme; however, Defined benefit plan can effectively implement implicit contracting with the intention of offering employees with a caring wage floor (Owsiak 2018).
Portability and Termination- It is generally stated that the considerations of portability are favouring IC plan. The real justification is that employees in a Defined Benefit scheme who leaves their work for reasons that he/she cannot control future penalties indexation of benefits will accrue. It is also stated that there exist implied contracts between firms and employees which necessitate more significant pension accrual and wage for the employees who are highly tenured. Therefore, when the employees terminate employment, it causes a forfeiture of the ability to perform the work for favourable rates of the total compensation. By using this reasoning, IC plan remains more portable (Nkeki 2018). The issue of portability closely tied to the pattern of accrual. For IC plan that has the rates of contribution linked to age and tenure, the forfeit to early termination can be as higher as compared to DB plan. In most case, the prices of gift for IC plan are not often tied to tenure, and they are not always back-loaded as DB plan. So, in reality, it would seem that the consideration of portability does favour Investment Choice plan as compared to the Defined Benefit plan (Cheok, Pressey, Weeks, VanDerWal and Storlie 2018).
DB versus Investment Choice Annuity Plan
Incentives- The benefit received from Pension in IC plan is based on the patterns of wages of the entire career of workers. Whereas, most of the DB plan benefit is based on the average salary of the employees. Therefore, employees in DB plan must have the higher incentive to sustain a more top effort level over their entire career to attain a high career salary. The Final wage in Defined Benefit plan has better leverage due to its more significant influence on pension benefits (Kruijf and Vries 2018).
Wage-Path Risk- DB plan pegging of benefits in their end average wage would seem to offer workers with maintenance insurance which the IC plan does not have. A situation where the wages path is not clearly defined mostly at the beginning of the career, then most of the employees will view it as risky of having their retirement benefits which are based on final salary. Some workers might desire a retirement benefit which depends upon the average earnings of career to remove too much dependence on realized pay in last years of them being in the job. IC scheme achieved the features .of time-averaging, since benefits will rely on the amount, contributed in every year of service (Alexander, Marina, Aidai and Andrey 2018).
Interest Rate Risk- one primary cause of risks in IC scheme is the transformation of stock of retirement to flow of retirement income. Defined Benefit scheme offer life annuities, efficiently guaranteed to the employees of their IR at retirement. This type of guarantee is known as nominal not the real IR. The value of the nominal-rate warranty is mostly being affected by inflation. IR uncertainty, therefore, appears to be the central determining factor of the comparative benefits of Defined Benefit scheme as compared to IC plan (Bass, Greenberg and Kishinevsky 2018).
In a situation where the markets were complete, the employees did not have to select the pension plan because the workers could use securities to trade in the market. There exist two critical abnormalities in the entire markets that make the design of the pension vital from the perspective of the employees (Milstead 2018).
Inflation- There is the existence of controversy surrounds the indexation degree during the active life of the workers. Many researchers’ states that firms’ wages that administer Defined Benefit plan should not be projected of keeping pace with the level of price. This can be done by considering the degree of an unexpected rise in the level of pay. The increase inflicts a material loss on employees because the pension benefits of the workers are defined using nominal terms. Therefore, the loss of employees is the gain of the firms (Rhea 2018).
Investment Choice and Performance
Time horizons
The time horizons will enable the employees to create a portfolio; the employees have the responsibility of realizing that volatility causes more risk in the short term as compared to a long time. In a situation where the employees have approximately more than 20 years to retirement, then the market volatility that triggers the value of their investments to fall may not cause immediate danger since the employee has many years to recover. When the employees experience the same volatility a few years before they retire can disrupt their plans. Therefore, it is quite essential for all the employees to place limits close to the time frame of their investments (Schuck and Rabe 2018).
Short-term-They are goals less than less than five years. Using the short time horizon, if the market experiences a drop, then it means that the due date in which the actual amount of money will be required will be very close. Therefore, the portfolio will have limited time, the recovery process in the market then drop. The employees can reduce the risk, of loss by holding investment cash-like or cash (Cobb 2015).
Long-term (time horizon) – represent goals of more than ten years. In this time horizon, the stock will give higher rewards. There is also higher risk associated with the event. The time is also available for the employees to regain the loss suffered.
Conclusion
The paper discusses the factors that the employees have to consider when deciding on the investment choice plan. From the discussion, it is true that Risk and time are the main factors that the employees have to admit. This is because any form of investments is made up of risks and the level of risk depends on the time duration or time horizons
References
Alexander, N., Marina, K., Aidai, Z.K. and Andrey, S., 2018. Institutional Risks: General Principles of Influence on Pension Systems. In Eurasian Business Perspectives (pp. 357-365). Springer, Cham.
Bass, B., Greenberg, D. and Kishinevsky, M., 2018. Strategic Portfolio Allocation With Factors. In Factor Investing (pp. 265-283).
Bithas, K., Latinopoulos, D., Kolimenakis, A. and Richardson, C., 2018. Social benefits from controlling invasive Asian tiger and native mosquitoes: a stated preference study in Athens, Greece. Ecological Economics, 145, pp.46-56.
Charlton, R. and McKinnon, R., 2018. Pensions in development. Routledge.
Chaudhry, N., Yong, H.H.A. and Veld, C., 2017. Tax avoidance in response to a decline in the funding status of defined benefit pension plans. Journal of International Financial Markets, Institutions and Money, 48, pp.99-116.
Cheok, , Pressey, R.L., Weeks, R., VanDerWal, J. and Storlie, C., 2018. The plans they are a?changin’: More frequent iterative adjustment of regional priorities in the transition to local actions can benefit implementation. Diversity and Distributions, 24(1), pp.48-57.
Cobb, J.A., 2015. Risky business: The decline of defined benefit pensions and firms’ shifting of risk. Organization Science, 26(5), pp.1332-1350.
de Kruijf, J.A. and de Vries, M.S., 2018. Contextualizing the trend from output to outcome measurement: the Dutch pension system. Public Money & Management, 38(1), pp.65-72.
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Kriz, K.A. and Chen, G., 2017. How Well Does the Risk-Free Rate Predict the Future Rate of Return on Investments? Implications for Public Defined-Benefit Pension Plans. Municipal Finance Journal, 38(1).
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Milstead, D., 2018. Issue: Pensions Pensions.
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Owsiak, K., 2018. The Impact of Pension Reforms on Public Finance in Poland. In Eurasian Economic Perspectives (pp. 133-151). Springer, Cham.
Paradi, J.C., Sherman, H.D. and Tam, F.K., 2018. Securities Market Applications: Pension, Mutual and Hedge Fund Insights with DEA. In Data Envelopment Analysis in the Financial Services Industry (pp. 207-231). Springer, Cham.
Rhea, H., 2018. Cost-Benefit Analysis of Retirement Plans.
Schuck, A.M. and Rabe-Hemp, C.E., 2018. Investing in people: salary and turnover in policing. Policing: An International Journal of Police Strategies & Management, (just-accepted), pp.00-00.
Vercellini, P., Frattaruolo, M.P. and Buggio, L., 2018. Toward minimally disruptive management of symptomatic endometriosis: reducing low-value care and the burden of treatment.
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