Defined Benefit Pension Plan and Defined Contribution Plan
Pension fund is defined as any fund put away as savings for the benefit of a retiree. The pension fund provides income for the retired persons giving an assurance of financial security even after the retirement age. The pension funds defer in regard to the institution or organisation in question. Pension funds may be in a form of money or plans which are done in order to provide income. They provide a good source of investment in a company which may be private or public. Pensions assure an employee of a comfortable life even without working. An employee is, therefore, able to live up to the standard they have attained while working even after they have stopped doing this. There are two types of pension funds, and these are defined benefit pension fund and defined contribution pension fund.
Defined benefits and defined contributions are the two types of employer pensions that are used for the benefit of retired employees. Plans whereby the employees are guaranteed by their employers a fixed monthly income for the rest of their lives are known as defined benefit plans. This monthly income is calculated using final average pay calculation method, the dollar times service calculation or a variation, or a combination of the two calculation methods. These two methods are mainly used in the USA, and other countries have got different calculation methods. The dollar times service calculation is computed by multiplying a certain dollar amount by the number of years the employee has worked for the company. The time period used can be years or months depending on the company and the dollar amount. Therefore, the longer an employee has worked for the company, the greater their retirement benefit. This benefit plan thus favours employees who have worked in a company for a long time if to compare to those who have worked for the shorter periods of time.
The final average pay method, on the other hand, is computed by calculating a certain percentage of the employee’s salary for the last few years prior to their retirement as determined by the employer. In most cases, it is 3 to 5 years, but it could be more or less depending on the company policy. The employees’ total annual salary for the last couple of years is summed divided by three years or the number of years agreed upon by the company and employer and the employee, then the computed amount is multiplied by the percentage amount that has been predetermined. In most cases, employers average three of the highest annual salary earned by the employee in the last ten years rather than the last three years. People who are paid with a basic salary plus additions that vary such as commissions and overtime wages benefit from such a plan.
In most cases, companies who give defined benefit plans use one of the above methods to compute the amount but include other factors in the computation as well. However, whatever the method used, the main idea here is for the employer to offer a guaranteed amount of income every month to the employees for the rest of their life, and this is the basis of the defined benefits plan. The benefit plan is fair for all the employees in the organisation or company regardless of their former salary. It only depends on the agreement between the employer, the employee, and the organization at large.
Defined contribution plan is a plan in which the employees receive a certain fixed amount deposited into their pension fund every year from their employer. This amount accumulates and, in some cases, generates income or interest and the employees receive it upon retirement. The amount of income received, therefore, is dependent on the total accumulated amount inclusive of interest, and the longer the employee has worked for the company, the more the pension amount is. Examples of defined contribution plans are the 403(b) plans that are offered by non profit and public employers and the 401(k) plans that are usually offered by employers to employees in the private sector. The total amount of the pension can comprise of contributions made by both the employer and the employee or contributions made by the employer alone.
The main difference between the defined benefit plan and the defined contribution plan is known as market risk. Market risk is defined as the risks that arise from the variations or changes in the value of the pension investment in the different plans. In addition, to being a savings plan, the point of putting money away for retirement is to have it multiply and generate extra income. The money put away has to be invested in some profit generating ventures or in lucrative assets that produce income. This money is invested in real estate, stocks, bonds, and other income producing assets in addition to gaining interest. However, the value of these assets varies and fluctuates as evidenced by the recent market crashes. This usually is the basis of market risk.
In the case of defined benefit plans, market risks impact the amount the employer contributes, and it is, therefore, an important factor. Market risks can be either bad or good for them. For instance, when the economy is growing and assets are increasing in value, the cost of money the employer needs to contribute to the pension, which is the cost of funding decreases significantly as the employers contribute less than they would have out of the current revenues while still being able to meet the obligatory payments pension contributions. In such a case, market risks are beneficial to the employer. As long as the asset values are rising, even if the economy is experiencing little or no growth such as periods of inflation, the employer still benefit because they are committed to pay a certain fixed dollar amount towards the employees’ pension fund, and improving the employees’ purchasing power is not their responsibility.
However, if the asset values should decrease as a result of markets going down, the employers are forced to contribute more money to the pension plan in order to cater for future obligatory payments they have to make towards the employees’ pension funds. The defined benefit plan is a secure plan for retirees because they receive the same dollar amount as income every month regardless of the prevailing market conditions. The prevailing market conditions affect the employers not the employees. When markets go down, and asset values decrease, the employers suffer because they are forced to deduct from their current revenues which increase the cost of funding and reduce their profits. However, when markets rise, the employers enjoy a significantly reduction in their pension contributions and increase their profits while being able to ensure the retirees receive the guaranteed amount of dollar income per month.
The employees’ income, under defined benefits plan, are not affected by market conditions, they are neither harmed by declining markets nor do they receive benefits from the rise in asset values as a result of improved market conditions. The employees, however, are harmed by the decline in the markets because even though the amount of income they receive is the same their purchasing power reduces and their living standards are lowered. Therefore, a change in economy affects the employees since the income does not change.
In the case of defined contribution plans, unlike the defined benefits plan, the retirees or employees bear the consequences of market risks. Defined contribution plans are of great benefit to the employees who have retired. When asset values increase, as a result of economic growth, the employees or retirees enjoy the benefits of having their wealth increase while their employers’ contributions remain the same because they cannot adjust their contributions downwards. The rising of investment values caused by inflation also benefits the employees in the sense that they watch the value of their pension funds rise, and the employers are still unable to adjust their contributions downwards. While the rise in value of their investment increases due to inflation, this does not necessarily improve their purchasing power because prices increase everywhere due to inflation. They, however, do not suffer the lower purchasing power, but the increase in their wealth allows them to maintain the same purchasing power they have had before, and, therefore, they maintain the same standards of living. Their living standards are thus not affected either negatively or positively. This allows comfortable living standards without any financial insecurity (Beam, 2004)..
It appears that the American government supports the defined contribution plan, as evidenced by the insistence of the abolition of the state pension system by the governor of Wisconsin. The governor was in support of having employees pay a part of the contribution so that the pension could be funded more securely. In fact, he proposes 401(k) plans whereby the government would contribute a certain amount of money to employees’ accounts every year, but they would not guarantee a specific monthly dollar income, as it is in the case with the defined benefits plan.
Of course, employees prefer the defined benefits plan because they know in advance the amount of money they will receive every month upon retirement. However, with the varying prevailing market conditions, more employers are shying away from the defined benefits plan. It is becoming more risky to guarantee the employees a fixed contribution every month for the rest of their lives in light of varying market conditions. The market conditions may, at some point, bring out the benefit as too little to maintain the employees due to constant fluctuations. Employers are becoming less sure of where they will be safe financially in the future. A famous quote by Benjamin Franklin states that death and taxes are the only two guarantees in life. The past couple of decades have contributed to the current fear of guaranteeing employees a fixed contribution upon retirement. The recent financial crisis and instability have caused many companies that were considered financially strong to go suddenly bankrupt. As a result, thousands of retirees have had to take their pensions cut off because the companies, they had worked for, had gone bankrupt and were no longer in operation. This is the biggest risk the employees under defined benefit plan face. Under the defined contribution plan, the retirees are more secure because their pension fund is not entirely up to their employers or dependent on whether or not their employers or the unions that are responsible for their pension fund management stay in business (Company, 1995).
Companies that offer defined benefit plan but suddenly find themselves out of operation also suffer because they have to plead the authorities to release them from their contractual obligations to their employees. The defined benefit plan is becoming rare for the above reasons. Most companies are increasingly opting for the more secure defined contributions plan. These plans usually work best if instead of being established as a free standing entity, the pension is sponsored by the employers but run by a different entity. The law requires that the employer funds the pension to meet all the existing obligations. A going concern and solvency valuation have to be completed. In this case, the pension may not continue to grow if the sponsoring employer should go out of business, but at least the accumulated amount as of that period would still be available.
The Shift from Defined Benefit Plan to Defined Contribution Plan
As mentioned earlier, the defined benefit plans are gradually but surely losing their dominance in the corporate world. More employers in more countries, including those that previously offered defined benefits plan, are opting for the defined contribution plan. In fact, in some countries, defined contribution plans account for a significant part of the invested assets in the occupational pension plans in the private sector. This shows that most employees are taking into consideration the constant change in market and also the inflation problem. This shift has transferred investment risks associated with pension funds from the corporate sector to the households. By default, households had been exposed to the financial markets, and lately, the retirement income has varied greatly if to compare to the prevailing market variations. Many governments are in support of this shift and view it as a way of making households actively participate in the financial market. This shift has been adopted by the developed countries whose occupational pension system is mature. Lately, however, even emerging countries have begun to adopt this shift. This is a good indication of the maturing pension system in such countries (Clark, 2003).
This shift can be attributed to a couple of factors, besides security. One of the major factors is the increasing mobility of the labour force with the industrial and demographic change. Nowadays employees are always on the move in a bid to take advantage of emerging opportunities. Defined benefit plans are beneficial for the long term employees, a status held by many employees in the past. Employers who are always on the lookout for better opportunities view the defined benefit plan as somewhat restricting and will therefore opt for the defined contribution plan. Defined benefit plans cannot be transferred from one employer to another, another reason for the recent preference for defined contribution plans. Therefore, most employees prefer the defined contribution plan which allows a transfer from one employee to another.
Other factors that have also led to the tendency towards defined contribution include the rising cases of pension underfunding because the long term interest rates are increasingly declining, the tendency towards accounting that is more market based, uncertainty and the obvious effects of length of plan costs. This shift has got a couple of advantages for both employers and employees. One of the biggest advantages is that it reduces accrual risk and, therefore, supports the mobility of the labour market. Defined benefit plans are back loaded, that is, they are not portable from one employer to another, such that should the employee change employers, they lose a large portion of the expected benefits. Therefore, this kind of plan would not be beneficial for a mobile workforce. Under defined contribution plans, the assets belong to the employee and are, therefore, transferable from one employer to another as the employee moves. On the other hand, the defined contribution plan tends to shift the market risk from the corporate sector, which is the employer, to the employees, that is, the households and this influence the financial stability of the economy.
Asset allocations between defined benefit plan and defined contribution plan are similar in most countries. However, a major difference that has been found in asset allocation between the defined benefit plan and defined contribution plan is that the defined benefit plans often have their assets in fixed income securities and equities; while the defined contribution plan often has its assets in mutual funds (McGhie, 2007).
The defined contribution plan has some disadvantages too. One of them is the fact that households cannot be counted on to appropriately manage risks. For instance, most employees invest quite heavily in the stock of their own company. Therefore, they lack a sufficient diverse investment portfolio which in turn affects their risk tolerance, investment objectives, and constraints.
The shift toward defined contribution plans can be attributed in large to changes in the composition of the labour force and the industrial structure which have increased labour mobility. Defined benefit plans are only beneficial to employees who work for the same employer for a long period. The defined contribution plan, therefore, works best for workers who do not stick to the same employer over time.
These plans have a couple of things in common. One of them is that investment income and plan contributions are not subject to personal income tax. Withdrawals, however, are taxed. For both plans, the beneficiaries are not allowed to withdraw early. Both plans offer the retirees a fixed amount of income upon retirement for their upkeep (Weltman, 2011).
Defined benefit plans offer protection for the employees upon retirement at the expense of a risk borne by their employer. The employers bear the consequences of variation in market conditions whether they are beneficial or harmful. This plan seemed to work in the past when there was less workforce mobility and more job security. It also worked best when economies were more stable, and the uncertainties of the financial market were more under control. However, defined benefits plan has become more risky for employers and too restraining for the present workforce. Not only it does restrain the workers, but it also keeps the employers bound to an obligation whose fulfilment is dependent on factors they cannot control such as the market conditions and financial stability of the economy (Beam, 2004).
On the other hand, the defined contribution plan works well for the current mobile workforce and the prevailing uncertain financial market. Not only it does relieve the corporate sector of the obligatory burden to take care of their retired employees, it benefits the employees in two ways. Employees can move from one employer to another and take advantage of emerging better work opportunities without losing out the expected future benefits. Employees also benefit from market conditions that favour the value of their investments or assets (Merton, 1985).
Clearly pension plans involve a lot of work and often cost the employers and the employees. However, employers who offer an attractive pension fund attract employees who are more committed and who are more productive. This in turn ensures that the goals and standards of the organisation or company where the employees are working are achieved. Their productivity can be attributed to the fact that they have a plan for their upkeep upon retirement and hence can concentrate on the present, in this case, their current jobs. The better the pension plan package is, the better the performance and productivity of the employees are, thus the better the success and progress of an organization or company.