Defined Benefit Plan
Discuss about the Portfolio Risk Of International Diversification.
The important factors that should be considered while placing their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan
The aim to encourage the employees to save and invest their superannuation fund has been growing from the past two decades in Australia. The government of Australia has taken preemptive actions in this regard for mandating the minimum contributions to be made with reference to retirement and superannuation funds by the companies on behalf of their workers.
The minimum level of the contribution of the employers had been introduced at 3% of the salaries of the employees and has increased to a contribution of 9%. Furthermore, employees are also motivated to allot a part of their salaries to the superannuation investment. Due to the superannuation laws and increasing awareness amongst the workers to invest their savings for the future, there are millions of dollars flowing to the financial institutions who invest the funds so that they can provide sufficient income to fund the non-working individuals such as unemployed and the retired people (Inderst and Croce, 2013).
As a result, superannuation and mutual funds are amongst the largest investors in the Australian financial markets specifically in the equity shares of the listed companies on the national and the foreign stock markets. So, in this essay, the crucial factors to be considered regarding the investment of the superannuation fund in the defined benefit plan or the investment choice plan by the employees working in the tertiary sector will be stated. Furthermore, the importance of issues pertaining to the concept of time value of money and taxes in the decision making shall be analyzed (Bonizzi and Churchill, 2016).
As per the name, the defined benefit plan is the one in which the employee can avail the benefits paid at the retirement. These are calculated using a formula in which the determinants are age of the employee, his final average salary and the total years of service. So, the retirement benefits using the defined benefit plan can be calculated as: retirement benefit = benefit of the salary length of membership lump sum factor average size fraction (OECD, 2016).
For the employees who select to invest in defined benefit plan, their investments are pooled in the asset portfolio in the defined benefit plan .As the final return is calculated by the above mentioned formula, the performance of the asset portfolio is irrelevant and it does not have an impact on the final payment which is given to the client at the time of his retirement. It also indicates that the employee does not gain any benefits from their investment in the asset portfolio. The trustees of the defined benefit plan do not right to pay the extra monetary benefits derived from the annual adjusted basis (Bams, Schotman and Tyagi, 2016).
Investment Choice Plan
The employees selecting the Investment Choice Plan maintain a separate investment account which consists of contributions which are sponsored by employers and their personal superannuation contributions along with the returns earned on their invested contributions and the administration and management charges are deducted from the amount( Cunha,2018). The employees can select the type of assets or portfolios in which their superannuation contributions will be invested in. They would be given a choice to select from the four investment strategies viz. Stable Fund which are bonds and securities yielding fix returns with a small exposure to the shares and properties of the domestic and overseas market. The Secure Fund is attributed to the fixed interest securities and cash of the Australian market (Kup?ík and Gottwald, 2016).
The Share Funds are sole investments in the national and overseas market and The Trustees Selection Funds are the balanced fund relating to the property assets, private equity and infrastructure investments and stock of the national and international market.
These can be differentiated by their risk and return attributes. Amongst all these the secured funds are the ones with minimum risk and they provide the least average returns. With the help of Investment Choice Plan, the employee can choose from a variety of investment options which are dependent upon the risk taking capacity of the individual. For example: a higher growth option would have the highest risk and more returns over a short period of time as compared to a conservative option which offers low risk and lower returns over a long period of time (ASIC,2018).
The factors responsible for the decision making of the employees regarding their investment in the defined benefit pension plan and Investment Choice Plan are explained here under. In the case of defined benefit plan, the employees receive a fixed amount on monthly basis from the retirement till their death or the death of their spouse. It is generally based on a formula which is connected with the salary or wages and the tenure of the service.
In this plan the employee earns a part of pension which is expressed as a percentage of the nominal earnings for every year of service. The employers are generally under legal obligation to make the payments but the firms are under no compulsion to pay the expected benefits which are yet to be accrued. So if the employer wants to terminate the benefit plan on his behalf he has to face penalties for the closure. However, the plan can partially be closed by him through the following ways. Soft freeze which restricts the increase in the number of members entitled to the accrued benefits but may allow the enhancement in the amount of compensation (Cannon and Tonks, 2012).
Factors Responsible for Decision Making
Hard Freeze or termination pertains to the restriction in the additional benefits received by the current plan members due to time period or increase in the compensation whereas in partial freeze, the plan is frozen for some of the members. So, the employees opting for the Defined Benefit Plan may face the risk related to insolvency if the firm declared itself bankrupt at the time when the plan is less funded. However, the insolvency risk may be reduced through the formation of a pension benefit guarantee agency.
In the Investment Choice Plan the employees invest the funds in their individual accounts which are managed by the plan sponsors. The contributions are deducted from their pay and the matching amount is paid by their employers. The contributions are generally a fixed amount deducted from the earnings; the securities in which these amounts are invested generate a stable rate of return over time. So in the investment choice plan, these are the contributions instead of the fixed benefits as in the defined business plan. Furthermore, the income which is to be received at the time of retirement is not known in advance. The benefits of the pension plan will entirely depend on the contributions made during the service tenure and the returns earned through the investments (PWC, 2016).
The issues pertaining to the concept of the time value of money and taxes etc. are crucial in the decision making process of the employees. According to Whitehouse (2018) the taxation implications in the pension plans apply when the money is contributed to the fund by the workers and their employers resulting in the capital gains arising on the investment income. Another incidence of taxation occurs when the retried members receive the benefits. The tax implications comprise of the contributions made by the employer, the employees and the personal contributions for which a tax deduction was claimed. However, the tax free components consist of after tax contributions and government co-contributions (Wal, 2014).
So the superannuation in Australia is taxed according to Australian taxation system and the tax liability arises on three point’s viz. investment income earned by the fund, contributions received by the superannuation fund and the benefits paid by the fund. The contributions in the superannuation are of two types, the before tax contributions and the after tax contributions. The concessional or before tax contributions are attributed to the employers who receive a tax deduction. They comprise of superannuation guarantee contributions, other types of contributions and salary sacrifice contributions which are claimed as personal tax deductions by the employer. The non-concessional contributions are referred to as after tax contributions for which nobody receives a tax deduction. They are not taxable amounts in the fund (Farrell and Shoag , 2015).
Time Value of Money
However, according to Australian Taxation Office (2017) the ordinary and statutory income generated from the investment of the assets is exempted from income tax. It is known as exempt current pension income (ECPI).
According to Einfeld (2012) the two types of funds can be compared to calculate the benefits members get over time. For this the various elements related to time which is measured in years , the benefits received from the member’s accumulation fund and the defined benefit received from the members will be considered. Furthermore, multiplication of benefits of the defined benefit fund, the years of service by the members, the contribution rate of the employers and the salary of the commencing year will be analyzed. The growth rate of the salary in the future and the rate of investment in earnings post tax in the future will also be calculated.
For this the assumptions would be that the contributions are made at the end of the year and the salary growth rate remains the same from year to year. The conclusion of the analysis was the defined benefit plan are more attractive in the initial years of employment and the investment choice plan seems to be more feasible in the later years of employment. However, with the assumption of a contribution rate of 7.65% which is 9% of Superannuation guarantee less the contribution tax and benefits multiplying at the rate of 15% , the employees should switch to the investment choice plan at the time when they have completed half of their services.
However, various factors influence the decision of the employees for switching over to the investment choice plans. The first factor is fund solvency. Relying to the fact that over 20% of the Defined Benefit funds in Australia are facing a fiscal deficit where the employers from the manufacturing industries are incurring losses and are moving towards the decline.
Another factor is the capacity of the employees to switch the funds as not all the employers provide the opportunity for the employees to switch to the investment choice plan.
Additionally, the defined benefit fund offers an insurance cover which may be charged for or withdrawn if the employee switches to the investment choice plan (Sabitova, Kulakova and Sharafutdinova, 2015).
Although the defined benefit plan provides certain advantages to the employees, it is posed to some risks. The employer provides the retirement benefits to the employees which can be expressed as a definite replacement rate of the pre-retirement earnings of the employees. It poses the risk of the assets falling short to meet the obligation at the time of the retirement of the employee.
Taxation
The employers are also posed to investment risk as the actual returns on the assets set aside for the payment of the pension funds may fall short and it may compel the employers to raise the contributions. These can be hedged by investing in fixed income securities which match the payment of cash flows and the accrued liabilities.
As per the investment benefit plan of Australia, the participation of all the employees and employers is mandatory and the amount to be contributed by them is decided by law. The risks associated with the investment choice plan vary from those of defined benefit plan. In the former, the employees are posed to investment and durability risks. However, they are not posed to accrual risks. The employees are also confronted by market timing risks at the time of their retirement.
It applies not only to the availability of cash balances at the time of retirement but also pertains to the amount of annuity which can be procured from the aggregate amount. Thus a stock decline during retirement can reduce the cash balance in an investment choice plan.
Thus to conclude, it can be said that with the changing structure of pension system in Australia , firms are motivating the workers to participate in the Investment choice plan .However, within these plans , the employees are being accustomed with a new accountability to make various complex financial decisions regarding the both asset accumulation and decumulation phase.
In this essay, the various aspects of defined benefit plan and the investment choice plan are analyzed and it has been concluded that returns of the investment choice plans are better than defined benefit plan. It can be explained with the help of one example:
If AS$1, 00,000 are invested in Defined Benefit plan and Investment choice plan simultaneously for 10 years and the rate of interest is supposed to be 15% p.a., then the yearly returns would be approximately AS$15,000 which can vary according to the length of the service period of the employee and it would be received by him or his spouse till their death. On the other hand if the mount is invested in the Investment Choice Plan, then the returns would be compounded on the basis of the value of the assets in which the fund is invested. So, it would yield returns on compounded interest per annum which would be much more than the returns of the defined benefit plan (Aliu and Knapkova, 2017).
Conclusion
In order to invest in the defined benefit plan, the employee has to stick to the job for a definite time as for the calculation of the benefits, the service length and the average salary earned by the employee during the last few years is calculated. It is not necessary in the case of in the case of investment choice plan (Bateman and Morris, 2014).
References
Aliu, F. and Knapkova, A. (2017) Portfolio Risk of International Diversification of Kosovo Pension Fund: A Historical Perspective. Acta Universitatis Agriculturae Et Silviculturae Mendelianae Brunensis. 65(1), pp. 237-244.
ASIC (2018) Super investment options [online] Available from: https://www.moneysmart.gov.au/copyright [Accessed 11th May, 2018].
Australian Taxation Office (2017) Self-managed super funds and tax exemptions on pension assets [online] Available from: https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/SMSF-resources/SMSF-technical/Self-managed-super-funds-and-tax-exemptions-on-pension-assets/ [Accessed 12th May, 2018].
Bams, D. , Schotman, P. and Tyagi , M.(2016) Asset Allocation Dynamics of Pension Funds. Network for Studies on Pensions, Aging and Retirement [online] Available from: https://arno.uvt.nl/show.cgi?fid=140039 [Accessed 14th May, 2018].
Bateman, H. and Morris , N.(2014) Pension fund efficiency: an international comparison of Australian performance [online] Available from: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2648743 [Accessed 14th May, 2018].
Bonizzi , B. and Churchill, J.(2016) Pension Funds and Financialisation in the European Union. Revista de Economía Mundial.46(2017),pp. 71-90.
Cannon, E. and Tonks, I.(2012) The Value and Risk of Defined Contribution Pension Schemes: International Evidence [online] Available from: https://pdfs.semanticscholar.org/6334/6aa14695aa1b93896a5025438181ddc12f49.pdf [Accessed 14th May, 2018].
Cunha, C.M.P.D. (2018) Sponsor Bias in Pension Fund Administrative Expenses: The Brazilian Experience. Brazilian Administrative Review .15(1),pp. 1-23.
Einfeld , G.(2012) Are Defined Benefit fund still beneficial ? Actuaries Institute [online] Available from: https://www.actuaries.asn.au/Library/Events/FSF/2012/FSF2012PaperEinfeld.pdf [Accessed 12th May, 2018].
Farrell, J. and Shoag , D.(2015) Asset management in public DB and non-DB Pension Plans. Journal of Pension Economics and Finance. 15(4),pp. 1-28.
Inderst, G. and Croce, R.D.(2013) Pension Fund Investment in Infrastructure: A Comparison between Australia and Canada. OECD Working Papers on Finance, Insurance and Private Pensions, NO. 32 . OECD Publishing.
Kup?ík, P. and Gottwald, P.(2016) The Return-Risk Performance of Selected Pension Fund In OECD With Focus On The Czech Pension System. Acta Universitatis Agriculturae Et Silviculturae Mendelianae Brunensis. 64(6),pp. 1981-1988.
OECD (2016) Pension Markets in Focus [online] Available from: https://www.oecd.org/daf/fin/private-pensions/Pension-Markets-in-Focus-2016.pdf [Accessed 14th May, 2018].
PWC (2016) Global Pension Funds : Best Practices in the pension funds investment process [online] Available from: https://www.pwc.lu/en/asset-management/docs/pwc-awm-global-pension-funds.pdf [Accessed 14th May, 2018].
Sabitova, N., Kulakova, S. and Sharafutdinova, I.(2015) Non-State Pension Funds in the Retirement Insurance System of the Russian Federation: Trends and Prospects. Procedia Economics and Finance .27 (2015) ,pp. 224 – 229.
Wal , D.V.D.(2014) The measurement of international pension obligations – Have we harmonised enough? [online] Available from: https://www.dnb.nl/binaries/Working%20Paper%20424_tcm46-307802.pdf [Accessed 14th May, 2018].
Whitehouse, E. (2018) The tax treatment of funded pensions. Organization for Economic Co-operation and Development [online] Available from: https://search.oecd.org/finance/private-pensions/2391559.pdf [Accessed 12th May, 2018]
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