Pension is fund that is built during the working life of the employee and then used to secure the income after retirement. These funds can be operated by employer (occupational pension) who invests over time or alternatively employee can invest in a fund of their choice (private pension scheme). Both of these schemes generate income after retirement.
The pension funds are operated in many countries. According to international financial service the UK pension fund is $1,464 billion, Germany had $268 billion and France had $164 billion.
Pension schemes are of two major types:
Defined benefit scheme
Defined contribution scheme
DEFINED BENEFIT SCHEMES:
Define benefit scheme is also known as final salary scheme which stipulate a particular level of income after retirement normally based on final salary and length of service. Although there is a compulsory contribution by the employee, most of the cost of the benefit and risk of the investment is borne by the employer.
For example, in most of the public sector pension schemes, UK employers pay 60% of the cost of providing the benefits and members pay 40%.
Various factors which effect the contribution includes:
Value of the scheme assets and investment yield.
The composition of scheme membership.
Rate of salary growth of the scheme members.
Longer life span after retirement.
Changing regulatory requirements.
Contributory Defined Benefit Scheme:
In this case the employees make contributions to the pension scheme. Final Salary Schemes and Career Average Salary Schemes are the contributory Defined Benefit Schemes.
Final Salary Scheme: In this case the pension amount is calculated on the basis of the final salary of an employee in that company. From the employer’s point of view these are expensive as compared to other pension schemes. The contributions for are made by the employee for the pension scheme.
Career Average Salary Scheme : It calculates the pension amount depending upon the average earnings over the total number of years an employee works in a company. The benefits would be a percentage of the average salary earned by an employee during his career in that particular company. As compared to final salary scheme they are less costly for the employers. In this case also employee contributes in the pension scheme.
Non- Contributory Defined Benefit Scheme: In this case the emploer instead of employee is responsible for the contributions in the pension scheme. Cash Salary Scheme is the non contributory Scheme.
Cash Salary Scheme: This is a non contributory defined benefit scheme. In this case employer contributes a particular amount of money each year on behalf of the employee. They are a combination of defined benefit scheme and defined contribution scheme. For this reason they are also called as Hybrid Schemes.
Decline in Defined Benefit Schemes:
In define benefit scheme employer bears most of the risk as well if the pension fund become insufficient either due to poor investment performance or large salary increases, employer must replenish the pension fund out of business revenues. Operating such scheme on average earnings rather than final salary can help to protect against higher rate of salary growth.
Munnell and Soto found that many firms have “frozen” define benefit plans since 2003. There are Following are the number of factors which have been used by employers to explain the decline of defined benefit schemes which are described below:
Source : http://www.opalliance.org.uk/decline.htm
DEFINED CONTRIBUTION SCHEMES
Defined contribution schemes are also known as money purchase scheme in which the employee and/or employer make contributions into a pension fund according to prescribed rules. At retirement the pension fund is used to buy annuity which is an income guaranteed for life of the recipient. Most of the personal pensions are of his type. Under defined contribution schemes following factors determine the pension income available at retirement.
The contributions invested in the scheme;
Product provider charges;
The performance of the pension fund;
The annuity rate at retirement date
The main factors that determine the benefits at retirement are the contributions invested by the employee, the return on investment earned, Annuity rate, the type of annuity selected and the charges of the scheme. Due to the characteristics and benefits of this scheme, this is the most popular type of pension schemes used in UK. These contributions cover a wide variety of private and occupational schemes. In this case the risk of poor returns on investment or high cost lies with the employee instead of employer. The employees cannot forecast their pension as the return on investment fund is uncertain. The factors affecting the return like annuity rate, charges on investments and performance of investments are beyond the control of the employee. An employee can also be certain of the amount of investment made by him. In the initial stages of investment the contributions are invested in the investments where risk is high and as an employee reaches near his retirement his contributions are invested in comparatively less riskier investments. This provides a good combination of growth and security. Employees in this case can have tax relief on their contributions.
The pension fund in this case therefore includes:
Pension Fund = Employee’s Contributions + Employer’s Contributions + Investment Returns + Tax benefits
The contributions are invested in the shares and other investments with the aim of earning more return on these investments which can help in the growth of the pension fund before the retirement of the employees. Employees can choose the investments in which they want to invest. At the time of retirement employees can take a tax free lump sum amount from their pension and the remaining amount can be used to secure an income.
If an employee changes his job he can stop making payments to his fund and can leave it as it is with his previous employer. This is also known as Deferred or Preserved Pension. Otherwise with some additional cost and risk he can get it transferred to his new employer or a stakeholder.
Defined contributions scheme allows employees to make regular contributions. Employer can also opt for making contributions in the pension fund.
DIFFERENCE BETWEEN DEFINED BENEFIT AND DEFINED CONTRIBUTION SCHEMES.
The defined benefit and defined contribution schemes can be best differentiated by determining where the risks lie.
In a defined benefit scheme, the employer bears the vast majority of costs and if investment returns poor yield or costs increase, the pension fund can become insufficient and the employer must replenish the fund out of the business revenues.
Whereas in a defined contribution scheme the contributions are paid at a fixed level and therefore it is the recipient who bears these risks. If they are not able to increase contributions when fund performance is poor or cost increases, then their retirement income will be lower.
In UK there is an upper limit from a define benefit scheme where as there is no upper limit to the level of income generated from this scheme.
Defined Benefit Scheme
Defined Contribuion Scheme
Risk lies with the employer
Risk lies with the employee
Change in Value of Investment
Pension fund is fixed and pre determined.
Pension funds have the growth potential. They are flexible and can provide more return.
Affect of Market conditions
Market conditions do not affect the pension fund
Market conditions affect the return on investments made by the employees.
Economic conditions like inflation, affects the employees. As they receive fixed amount and the value of money decreases.
They have less affect of the economic conditions on the investments.
Cost to employer
These have high cost associated with them for the employer.
These plans have comparatively low cost.
Responsibility to make payments lie with the employer most of the times.
Employee is responsible to make payments
These pension schemes have a downward trend these days due to the cost associated with them for the employer.
They have an upward trend due to the less cost to the employers.
These are comparatively more certain. The same amount invested by two different persons provides the same return.
These are uncertain in nature. The employee knows the amount he or his employer invested but he is uncertain about the return on this investment.
The recent rush to close final salary pension schemes to new employees means that an increasing number of workers now have to rely on defined contribution (money purchase) schemes to provide their future retirement income, either through a scheme set up by their employer or a personal pension as a group or individual arrangement. Buessing and Soto’s (2006) analysis of data from Department of Labor Form 5500 filings shows that the number of individuals who participate only in a private sector define benefit plan has declined from 9.6 million in 1990 to 6.6 million in 2003.
The growth of private sector define contribution plans has given employees new responsibility for managing retirement assets and made retirement wealth accumulation a function of an employee’s contribution and asset allocation decisions. Accrued benefits in define benefit plans do not depend on financial market returns, except in extreme circumstances such as plan insolvency. Benefits in define contribution plans, however, are a function of financial market returns. Some analysts have suggested that define contribution plans expose prospective retirees to greater risk than define benefit plans because of this link.
Several recent studies have examined financial market risk in define contribution plans. Balcer and Sahin (1979) compare define benefit and define contribution plans in a lifecycle setting, recognizing that earnings uncertainty and job transitions have an important effect on the accumulated wealth of define benefit plan participants. Bodie, Marcus, and Merton (1988) note that define benefit and define contribution plans both entail risks, but that these risks are different. Neither of these studies make quantitative estimates of relative risks; two more recent studies do. Samwick and Skinner (2004) use data from the 1983 and 1989 Survey of Consumer Finances and the associated Pension Provider Supplement (PPS) to summarize DC and DB plan attributes. They generate synthetic earnings histories under the assumption that the logarithm of earnings follows a random walk with age-related drift, and they evaluate define benefit and define contribution wealth accumulation for these earnings histories. This approach may miss subtle stochastic properties of actual earnings histories. The results suggest that for many workers define contribution plan accumulations are likely to exceed the actuarial present discounted value (PDV) of define benefit plan benefits. Finally, Schrager (2005) uses data on earnings and job change patterns from the Panel Survey of Income Dynamics to study related issues. She finds that job turnover increased in the 1990s, making define contribution plans more attractive relative to define benefit plans for many workers. Both of the empirical studies parameterize the earnings and job change processes, thereby suppressing some of the richness in individual earnings histories.
One of the key risks in both define benefit and define contribution wealth accumulation is an “ex ante” risk that workers face when they accept a job: what does the firm’s define contribution or define benefit plan offer? There is substantial variation in the generosity of employer matching contributions in define contribution plans, and in the normal retirement age and level of risks that are realized as their working career unfolds. These include their earnings path, which is a key input directly to define benefit wealth accruals and which affects the capacity to make define contribution contributions, the economic fortunes of their employer, which may lead to changes in the retirement plan parameters, their job tenure and the number of jobs they hold over their working career, the choices they make in a define contribution plan, and the financial market returns that they earn on their define contribution plan investments. Some components of both the post-retirement benefits in define benefit plans. In addition to these ex ante risks, workers also face ex post ex ante and ex post risk are under the control of the worker, who may decide whether or not to work for a firm with particular pension characteristics, whether or not to voluntarily separate from a firm with a define benefit plan, or whether or not to contribute the maximum amount to a define contribution plan.
When employers try to compare the real overall cost of providing a typical defined benefit scheme with a typical defined contribution scheme, they usually fail to compare like with like. It is often forgotten that because employers tend to benefit from favorable investment returns with defined benefit schemes, many defined benefit arrangements have actually cost a lot less than contribution levels suggest if you take into account contribution reductions and contribution holidays.
Certainly when looking back beyond the recent troubled financial markets, it was not uncommon for defined benefit arrangements to be holding surpluses and/or to be taking contribution holidays. This will not be possible under a defined contribution scheme where the employer is required to maintain the agreed level of contributions irrespective of how well the investments are performing, subject only to the proviso that an individual cannot be over-funded (i.e. the benefits that can be purchased by their contributions cannot exceed the maximum as laid down by the Inland Revenue).
This will not always be the case and negotiators might like to remind employers of this fact during their deliberations. Where it does not prove possible to persuade the employer to maintain a defined benefit scheme for all employees then the objective must be to ensure that the defined contribution scheme agreed is essentially based upon contributions that will actually deliver an adequate pension for future retiring employees.