The Defined Benefit Plan
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.
The important aspects to be analyzed by the employees of the tertiary sector while investing their pension funds in the Defined Benefit Plan or the Investment Choice Plan
The main focus of this essay is to motivate the workers to save and invest their pension funds and to analyze the best plan to invest in out of the two famous investment schemes of the pension funds viz. Defined Benefit Plan and Investment Choice Plan in Australia. For this the government of Australia has been taking proactive actions for encouraging the employers to pay their minimum contributions in the retirement and superannuation schemes on behalf of their employees.
For this, the minimum level of contribution by the companies had been stated as 3% of the remuneration of the workers at the initial level and has now been enhanced to 9% of the remuneration of their workers. Additionally, the workers have also been encouraged to invest a part of their remuneration in the super annuity funds (Krzysztof and Dorota, 2015).
The superannuation and mutual funds are the largest investment companies in the financial markets of Australia and they invest their funds especially in the equity stock which is listed on domestic and international share markets. So, in this essay, the important aspects to be analyzed while investing the pension fund in the defined business plan and investment choice plan and matters relating to the concept of time value of money and taxes in the decision making process regarding the investment will be evaluated.
The government of Australia has introduced certain laws and legislations regarding the investment of the pension funds such as Superannuation Act 2005, Government of Australia Government Superannuation Schemes Act 2011 etc. (Australian Government: Department of Finance ,2015). As a result, many employees have become aware and have been investing their funds in the pension schemes due to which billions of dollars have been rolling into the financial institutions which further direct these funds so that they can provide monetary benefits to those which are unemployed and retired (Schechter ,2018).
The Investment Choice Plan
As the name suggests, in the defined benefit plan, the workers can take the advantages of the benefits which are received at the time of retirement. It is calculated by using a formula in which the factors to be considered are the age of the worker, the average salary earned during the last years of the service and length of the service. It can be calculated by many ways .One of them is the final average earnings. It is based on the average salary of the worker before retirement. The time period can be 5 years before retirement. The benefit percentage received from the employer can be considered as 2 %( Forman, 2012).
So, the formula is: Benefit percentage *average salary in the past 5 years * number of years the employee has been a member of the plan (Ilmanen et al., 2017).
Thus, if the employee has been member of the plan for 30 years and the average salary is AUS$50000 , then the calculation of the pension amount received per annum will be:
AUS$50000*2%*30= AUS$3000
So the employee would be receiving AUS$3000 yearly after his retirement till his death.
The employees who choose to invest in the defined benefit plan direct their investments into a pool of assets termed as ‘Asset Portfolio’. The final return is calculated by the above mentioned formula. The yield of the assets is unconnected to the impact on the final payment which is received by the client at the time of his retirement. It also reveals that the worker does not gain any advantage from investing their funds in the pool of assets. The employees are not entitles for the extra returns resulting from the annual adjusted basis (Li, Huang and Zhou,2014).
The employees who choose to invest in the Investment Choice Plan have to maintain a distinct investment account which comprise of contributions sponsored by the firms and the superannuation funds contributed by the employees. It also comprise of the yield earned on the investments along with the administration and management charges which are deducted from the amount (Ezra, 2015).
The employees have the privilege to choose from the type of assets in which the superannuation fund will be invested in. They can select the mode of investment from the four types of investment strategies viz. secured fund which comprising of the fixed yield securities and the cash held in the Australian market. Another is the stable fund which consists of bonds and stock having a fixed rate of return along with a small component of stock and property of the national and international market. The trustees’ selection fund is the investments pertaining to assets, infrastructure, stock and private equity of the domestic and foreign market. Lastly, the share funds are the funds invested in the domestic and international market (Farrell and Shoag, 2015).
Comparison of Plans
All the above mentioned plans can be compared on the basis of their risk and return. The secured funds are the investments which possess the minimum risk along with the least average earnings. The employees have the right to select from the various investment plans depending on their risk bearing capabilities (Turner, Kalamazoo and Upjohn, 2010).
There are various factors which assist the employees in deciding which plan is to be considered for the investment of the pension plan. In the case of defined benefit plan, the worker receives a definite amount in a fixed period of time until his death or the death of his spouse. The worker receives a portion of the pension which consists of the percentage of the income earned in proportion to each year of service. According to the law, firms have to contribute their part to the pension investment plan but they are not compelled to pay the extra benefits received from their investments. If the employer wishes to opt out from the benefit plan, he is bound to face penalties for the termination (Modugno, 2012).
Though the plan can partially be closed through soft, hard and partial freeze. In the soft freeze method, the number of members participating in the plan is restricted but the increase in the amount of compensation may be allowed in this plan. Hard freeze restricts the enjoyment of the additional benefits by the current plan members while in the case of partial freeze, the plan is terminated for some of the members.
The employees selecting the defined benefit plan might be confronted from the risk of insolvency as the firm can be declared as bankrupt at the time of payment of the amount. But this risk can be mitigated through the establishment of a pension benefit guarantee agency.
In the investment choice plan, the workers invest the amount in their separate accounts managed by the sponsors of the plan. The amount is reduced from the salary and same amount is paid by the company. The amount invested is a fixed amount is subtracted from the salary and the stock in which the amount is invested yields a fixed rate of return over a period of time. So, in the investment choice plan, the workers contribute to the fund and they receive fluctuating returns instead of fixed benefits as in the case of defined business plan.
Additionally the income which is to be received is not known beforehand rather it will entirely be dependent upon the investments made during the service tenure and the revenues earned through these investments.
Factors Affecting Decision Making
The issues relating to various aspects such as time value of money invested and rate of tax charged on the invested amount affect the decision making process of the workers. The tax liability arises when the money is invested by the employees and firm which results in the capital gains which are liable to tax. Another incidence emerges as a result of the receipt of the benefits by the retired members. The tax liability arises as a result of the investments made by the members and the firms for which the tax deduction can be demanded.
The superannuation funds in Australia are taxed in accordance with the Australian taxation system and the taxation liability arises on three stages namely investment received by the superannuation fund, benefits received from the fund and the income earned by the fund. The investments in the superannuation are of two types, the before tax and the after tax contributions .The before tax contributions are associated with the employers who can claim tax deductions. The salary sacrifice contributions and superannuation guarantee contributions are claimed as tax deductions by the firms. The after tax contributions are the ones for which no tax deduction can be claimed.
The two types of funds can be contrasted to compute the advantages for the members. The various elements such as time which is calculated in years, the benefits received by the members through the accumulation fund and the defined benefit shall be analyzed. For the calculation of the benefits derived from the defined benefit plan, the benefit percentage received from the employer, the tenure of service of the member and the salary of the last years of service shall be evaluated. Furthermore, the growth rate of salary and the rate of investment in earnings less the rate of tax in the future shall also be evaluated.
However, it is analyzed that the defined benefit plan seems to be more attractive in the primary years of service but in the later years the employees tend to switch to the investment choice plan. There are various aspects responsible for the decision making of the employees for the selection to invest in the pension plans. The first is the risk bearing capacity of the workers to switch amongst the two types of funds (Manor, 2017).
Another is the fund solvency. Most of the firm which have adopted the defined benefit plan in Australia are on the verge of bankruptcy .The plan also offers an insurance cover which can be withheld if the employee switches over to another investment plan (Cooper,2014).
Conclusion
Though the defined benefit plan has much benefit but it is posed to certain risks. The risks of assets falling short to meet the financial obligations at the time of retirement are one of the greatest risks posed by the fund. The employees are also posed to investment risk as the yield on the assets set aside for payment to can fall short at the time of reimbursement of benefits (Krishnan and Cumbie, 2016).
The risks pertaining to the investment choice plan are stability ,market timing and investment risks .The risk apply not only to the accessibility of the cash balances at the time of retirement but is also associated with the amount of return which can be retrieved from the total amount. Thus a decline in the share value during the retirement can decrease the cash balance in the investment choice plan. In this plan the amount of contribution is known but there is no guarantee of receiving benefits. The employer can claim tax deductions on his investments but the employees are not entitled to do so (VanDerhei, 2015).
Hence to conclude, it can be said that with the transition in the pension framework of Australia, the companies are trying to analyze the advantages and disadvantages of both the plans. So it has been concluded that the companies should evaluate the type of plans suited for the employees and then motivate the employees to opt for that particular plan so that they can be benefitted the most.
In this essay, the different aspects of the defined benefit plan and the investment choice plan are being discussed and it has been concluded that the Defined Benefit Plan benefits the middle class whereas the Investment choice plan benefits the wealthier class of the society.
According to Kleine and Bean ( 2014) a study of 2012 revealed that the defined benefit plan helps in generating earnings for the middle class whereas the investment choice plan helps in economic growth for the higher class. According to the research, the employees aged between 30-39 and having an income below $20000 participate in the defined benefit plan whereas 82% of those whose income exceeds $60000 participate in the investment choice plan.
So the companies should formulate the defined pension plan schemes for the lower income group and the investment choice plan for the higher income group (Orlova, Rutledge and Wu, 2015).
References
Australian Government: Department of Finance (2015) Superannuation Policy and Legislation [online] Available from: https://www.finance.gov.au/superannuation/policy-and-legislation/ [Accessed 14th May, 2018].
Cooper, J.R.(2014) Are Defined Contribution Pension Plans Fit For Purpose In Retirement? Seattle University Law Review.37(511),pp. 511-532.
Ezra , D.(2015) Defined-Benefit and Defined-Contribution Plans of the Future. Financial Analysts Journal. 71(1), pp. 56-60.
Farrell,J. and Shoag, D.(2015) Asset management in public DB and non-DB Pension Plans. Cambridge University Press.
Forman, J.B. (2012) Optimal Distribution Rules for Defined Contribution Plans: What Can the United States and Australia Learn from Other Countries? University of Oklahoma.
Ilmanen, A.,Kabiller, D.G., Siegel , L.B. and Sullivan, R.N.(2017) Defined Contribution Retirement Plans should look and feel more like Defined Benefit Plan. The Journal of Portfolio Management .43(2),pp. 1-16.
Kleine, R. and Bean, M.( 2014) A Cost Benefit Comparison Of Defined Benefit And Defined Contribution Retirement Plans [online] Available from: https://www.csr-mi.com/uploads/8/2/2/3/8223818/csr_report.pdf [Accessed 15th May, 2018].
Krishnan, V.S. and Cumbie, J.(2016) Defined Benefits Plans vs. Defined Contribution Plans: An Evaluation Framework using Random Returns[online] Available from: https://www.academyfinancial.org/resources/Documents/Proceedings/2016/4D-Cumbie.pdf [Accessed 15th May, 2018].
Krzysztof , K. and Dorota , W.(2015) Efficiency of private pension funds in Poland. The IEB International Journal of Finance. 2016(12), pp. 48-65.
Li, Y., Huang, Y. and Zhou, Y.(2014) Optimization of the Actuarial Model of Defined Contribution Pension Plan. Discrete Dynamics in Nature and Society.2014. [online] Available from: https://dx.doi.org/10.1155/2014/576213 [Accessed 15th May, 2018].
Manor, M. (2017) Efficient life cycle investment strategies in defined contribution pension plans in Israel. Journal of Insurance, Financial Markets and Consumer Protection. 26(4), pp. 47-66.
Modugno, V. (2012) The Effect of Changes in Retirement Plans on Employee Savings and Retirement Age and the Financial Impact on Employers of Delayed Retirement. Society of Actuaries’ Pension Section Research Committee.
Orlova, N.S., Rutledge, M.S. and Wu, A.Y. (2015) The transition from defined benefit to defined contribution pensions: does it influence elderly poverty? Massachusetts: Center for Retirement Research at Boston College.
Schechter, D. (2018) What is the difference between a Defined Contribution Plan and a Defined Benefit Plan [online] Available from: https://www.bsllp.com/what-is-the-difference-between-a-defined-contribution-plan-and-a-defined-benefit-plan [Accessed 15th May, 2018].
Turner, J.A., Kalamazoo, M.I. and Upjohn , W.E.(2010) Pension Policy: The Search for Better Solutions. U.S. Bureau of Labor Statistics.
VanDerhei, J. (2015) How Does the Probability of a “Successful” Retirement Differ Between Participants in Final-Average Defined Benefit Plans and Voluntary Enrollment 401(k) Plans? Employee Benefit Research Institute .36(10), pp. 9-23.
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