Difference between Defined Benefit and Defined Contributions Pension Schemes - Essay Example

Difference between defined benefit and defined contributions pension schemes By Foundation Finance and Accounting [University’ Name] [Department] 1 December 2014 Differences between defined benefit and defined contribution pension schemes 1.0 Introduction There are two broad categories of employer pension programs (also popularly referred to as retirement benefits plans). These are the defined contribution plans and defined benefits plans. The two are substantially different, and each has its unique features and characteristics. Recently, there has been a recognisable shift in preference of defined contribution plans to the defined benefits plans (Kruse 1995). The paper will expound on the differences between the defined contribution plans and defined benefits plans. The discussion will conclude by explaining reasons why there has been increased preference for the defined contribution plans. The discussion will, however, start by providing background information on the two plans. 1.1 Defined contribution plans These plans are abstractly simpler and involve the employer (and in some cases the employee) making regular contributions to the retirement account of the employee. The amount of contributions is predetermined, usually a specified fraction of the salary. This fraction is, however, subject to alterations in the course of the employee’s career. In this plan, the both contributions are tax-deductible although the investment income accumulates tax-free. In most cases, the employee decides on his/her choice of account investment. This may include investing in stock markets, bonds or any security that pleases them. At retirement, the employee can either receive an annuity or a lump sum, and the size of this money depends on the value of the accumulated funds in the employee’s retirement account (Poterba et al., 2007). The employee bears the risk of their investment and thus the employer has no any extra obligation beyond contributing to their employee’s retirement plan account. The valuation of defined contribution plans is simple and involves measuring the market value of the assets created in the retirement account. In most cases, the employee is guided in their personal financial planning by their defined contributions plan’s sponsor (Clark 1999). 1.2 Defined benefits plans Unlike the defined contributions plan which focuses more on the value of retirement account’s created assets, defined benefits plan focuses on the flow of benefits received by the employee at retirement. Typically, a defined benefits plan uses the employee’s wage history and the years of service as the determinants of the value of the benefit (Huberman, Iyengar & Jiang 2007). Upon retirement, the employee receives a defined monthly amount that is guaranteed for their life and that of their spouse. In some cases, the plan allows room for increase to cater for an increased cost of living during retirement (Lusardi & Mitchelli 2007). 2.0 Differences between defined benefits plans and defined contributions plans 2.1 Funding Defined contribution plans are typically fully funded, meaning the market value of the asset in the plan is proportional to the sponsor’s liability to the employee. Conversely, the valuation of the funding status of defined benefits plans is quite controversial and complex. The sponsor of the plan is not liable to any form of uncertainty in the investment chosen by the plan’s beneficiary (Choi et al., 2002). 2.2 Investment performance and choice The major and most recognisable risk to an employee in a defined contribution plan is the investment performance of the fund. However, this form of uncertainty can be controlled through measures such as selecting investments that have low variance rates of real returns. This provides the beneficiaries of defined contributions plans with lower risk investment options (Duflo & Saez 2002). Typically, defined contributions plans offer adequate flexibility to participants on the choice of investment to make using their funds. The investment, therefore, is largely dependent on the employee’s preference and circumstances surrounding the choices available. On the other hand, defined benefits plans force the participants to accumulate their retirement savings in the form of life annuities and this limits the fund’s risk-return choice. Defined benefits plans are essentially back-loaded, and in most cases, they choose contributions rate that is dependent on the rise in the worker’s age and period of service. The benefits in this plan are thus subject to circumstances such as wage inflation (Forman 1999). 2.3 Termination and portability In defined contribution plans, contribution rates are rarely tied to the employee’s period of service and thus are not as heavily back-loaded compared to the defined benefits plans. On the contrary, the defined benefits plans tie the employee’s benefits to tenure. This means that if a worker prematurely leaves his/her job, he/she risks losing future indexation of benefits that have already accumulated. The same principle is applied if a job termination occurs to an employee with a defined contribution plan that is tied to tenure or age (although this is rare). Therefore, it is easy to assert that portability factor favour the defined contribution plans more (Porteba & Wise 1998). 2.4 Incentives In defined contribution plans, pension benefits are widely dependent on the wage trajectory over the employee’s entire tenure in a career. On the other hand, the benefits in a defined benefits plan depend on the employee’s final average salary. This means that the final salary has a greater effect on what the employee in defined benefits plan gets for their pension benefits. This, therefore, motivates the employees in the plan to maintain high--level efforts in their entire tenure for a higher career-end salary. 2.5 Wage-path risk As earlier explained, pension benefits in a defined benefits plans are pegged to the final average salary. In most cases, this may appear as a type of income-maintenance insurance, which is unavailable in defined contribution plans. However, this kind of argument does not pose the exact picture as it is. This is because benefits in the direct contributions plans also depend on contributions made in each year of service instead of the final year of service (Porteba et al., 1996). On the other hand, participants in the defined benefits plans may view the plan as quite risky due to the high dependence of the plan on the final year average wage. Many employees will, therefore, prefer a benefits plan which is more tied to career-average earnings that are inflated adjusted for more reduced wage path risks. This is more achievable in defined contributions plans than in defined benefits plans. 2.6 Interest-rate risks As earlier noted, a primary source of uncertainty in defined contribution plans is the terms of converting the retirement funds into a flow of retirement income. This achievement is guaranteed in a defined benefits plan, through the life annuities offered in this plan. However, the defined benefits plan should have an indexation of benefits to guarantee the real estate interest rate. Otherwise, the value of the interest is bound to change if, for example, there is an unpredicted occurrence of a long-term inflation. 2.7 Administrative expense and complexity Defined benefits plans can be quite expensive to administer due to their complexity in benefits structures. They are in most cases subject to tax rules and accounting requirements and thus require high-skilled labour to determine their funding obligations. On the other hand, defined contributions plans are relatively simpler in their administration. They have a bank-like system of operation, and this makes them easier to explain to employees. 2.8 Inflation Comparisons of reactions of the two benefits plans to inflation can be analysed in two ways: preretirement inflation and postretirement inflation. If inflation occurs before retirement, the defined benefits plans are the worst affected. This is especially if the benefits are not indexed for inflation. On the other hand, a postretirement inflation most affects the defined contribution plans and may erode the value of the accumulated pension benefits. Conversely, defined benefits plans are not as much affected by postretirement inflation since most of these plans are public sector plans that provide automatic or periodic benefits increases to the retirees. 2.9 Influence on worker behaviour Due to varying modes of benefits accruement in defined benefits plans and defined contribution plans, the difference in incentives from each can affect the employee’s decisions about work and retirement. As earlier explained, defined benefits plans tie the retirements benefits to tenure and thus is seen as penalising employees who change jobs frequently. It is, therefore, seen as encouraging the workers to stay on their jobs as it creates larger incentives for this group. These are seen in the plan’s favour of older workers. On the other hand, the defined contributions plan encourage employees to accumulate as much as they can during their career since it is the accumulated amount of retirement fund that determines the interests on their assets (Friedberg & Webb 2005). 3.0 Reasons why defined contribution pension plans are becoming more important Traditionally, the retirement plans have taken the form of defined benefits. However, recent trends have shown a continuing growth of the defined contributions plans which is an indication of the ongoing shift (Costo 2006). There are numerous reasons to explain this shift: 3.1 Investment risk This involves the transfer of investment risk from an employer to the employee. There are several benefits of this arrangement although the major ones include the individual control over the risk-return trade-off and portfolio allocations. However, this can be disadvantageous if the resulting portfolios are not properly managed since it may lead to the participants incurring extra costs. This area has been covered by the defined benefits plans as they are liable to any risks involved in the fund. However, most participants would prefer to have control over their pension funds and thus the reason why most employers today are providing the defined contribution plans (Zelinsky 2004). 3.2 Regulatory and tax changes Defined pension funds are regulated by the legislation in a country, and this involves complex set of rules that regulate almost all aspects of the plans. This includes the plan’s funding, reporting, disclosures and coverage among others. The tax and regulatory restrictions have, therefore, discouraged most employers from supporting the defined benefits plan arrangement. The shift to defined contributions plans by the majority of employers has, therefore, been attributed to the costs of the regulations and also largely because of labour mobility. 3.3 Increasing costs of defined benefits plans Defined benefits plans involves the valuation of the expected present value of pension payments and wages and that should be at least equal to the discounted value of the wages that a worker can earn in the spot market (Chun, Ciochetti & Shilling). This has seen a rise in the level of accrued benefits and an extension of the postretirement periods due increased early retirements and longer life spans. The difficulties that firms encounter in such cases are brought about by benefits costs, longevity ad asset returns. This is due to factors such as litigation risks involved, regulatory restraints and the impact this can have on employees. However, workers value defined contributions plans differently from defined benefits plan, and this has led to the shift. 3.4 Increase in labour mobility Worker mobility has rapidly increased in the last few decades due to factors such as technological changes, changes in demographic composition of workers and industry composition of employment. Worker mobility has led to an increased demand for the more flexible defined contributions plan since it offers more advantages such as portability and even accumulation of funds in their careers. 3.5 Increased familiarity with the stock market Due to the increased popularity and familiarity with the stock market in most household today, defined contribution plans have grown in popularity. Most workers have, therefore, become increasingly interested in investing their retirements’ savings through the plan due to the control the offers to its participants (Gustaman, Mitchell & Steinmeir 1994). 4.0 Conclusion It is evident that the retirement landscape is gradually taking a different direction. The traditional defined benefits plans are slowly losing their dominance in the employer pension system in many countries today. The shift is especially beneficial to the employees who expect to change jobs severally in their career (Forman 1999). Defined contributions plans provide more control, flexibility and choice in terms of retirement savings’ management and investment. However, shifting to defined contribution plans has presented employees with numerous challenges that they did not face in the formerly dominant defined benefits plans. These challenges include inflation risks, market timing risks and longevity. Bibliography Choi, J. J., Laibson, D., Madrian, B. 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