Defined Benefit Plan Versus Defined Contribution Plan - Research Paper Example

Defined benefit plan versus defined contribution plan A defined benefit plan is a pension plan that awards an employee a specific monthly amount once he/ she retires. The reward is guaranteed to the employee personally over his life or to joint lives over his life and his spouse. The reward may include a cost benefit on the increase of living cost. The amount rewarded on a monthly basis is determined by length of service the employee has taken and his wages (Dorfman and Rajkumar, pg199). A defined contribution plan on the other hand, is a pension plan that gives a certain contribution reward to an employee account during his employment but no retirement benefit guarantee. The benefit the employee enjoys is determined by the contribution to, and earnings from investment of that plan. The benefit is exhausted when the account balance is at zero regardless of the employee’s age or circumstances surrounding him (Dorfman and Rajkumar, pg199). Ontario pension plan board has been operating under the defined benefit pension plan in the past. This plan has affected its operation of OTPPB negatively in the recent past due to the aging factor of the beneficiaries. The cost of pension is being pushed higher because of the life expectancy age of the beneficiaries getting longer nowadays. The life expectancy longevity has reached a point where the members retiring under this plan are likely to collect pension for a period that exceeds the time they have worked. The pension plan at the end of 2011 had 2600 pensioners who were 90 years older and above with the oldest beneficiaries being 109 years. The ratio of working teachers to each retiree is currently 1.5: 1 and the ratio is expected to rise to 1.3: 1 by 2020. With a large number of pensioners and whom their contribution to the project is lower than the time they are to receive benefits from the same initiative, it means that the pension plan is paying a huge amount of money that is threatening to exceed the contribution pooled from members contribution. At the end of 2011, Ontario pension plan board made benefit payment worth $4.7 billions while the contribution during the same period stood at $2.8 billions. This means that the benefit payment exceeded the amount that was contributed by members, government and the respective employers by $1.9 billions. This kind of deficit reduces the level of asset available in the pension plan that is supposed to be invested (Smith and Collie, pg88). This coupled with low interest rates underlying in the market currently has made it difficult for the board to forecast sufficiently the returns that will cover future costs of the pension. The sponsors of the pension plan are considering how to solve the problem to prevent future collapse due to financial shortage of the plan. Sharing of burden between the retiree and the working teachers is being considered in order to make the plan affordable and cover the shortfalls (Ontario teacher’s plan 2011). The management of the plan is considering shifting the risk of retirement to the employees in a way it will not endanger the survival of the aged teachers in their future years. Ontario teacher’s pension plan board has a funding management policy of 2003 which was adopted by the plan’s sponsor to guide how the pension plan is to handle cases of shortfall funding and surplus funding. Thus, to address the current shortfall funding facing the pension plan, the board has the capacity to increase the contribution rates, allow inflation protection condition provisions, lower other future benefits or it can apply some of these measures in combination. The sponsors of the plan made three changes to solve the preliminary shortfall of $17.2 billions on 1st January 2011. OTF and the Ontario government acted to solve on the forecasted shortfall of 2011 by exercising an inflation protection measures through invoking an inflation protection condition at 60%. With the base inflation adjustment set for 2012 being 2.8%, members of the pension plan are expected to be paid in 2012 at an indexation level of 1.68% (2.8% * 60%) on 2009 earning portion of members’ pension. A special contribution rate of 1.1% increase has being phased in over the next three years as by the government and respective employers as follows (Ontario teachers plan 2011); Year up to CPP limit above CPP limit increase 2011 10.4% 12.0% - 2012 10.8% 12.4% 0.4% 2013 11.15% 12.75% 0.35% 2014 11.5% 13.1% 0.35% total 1.1% Where CPP limit means the maximum earnings that CPP contribution and benefits are based on. The limit changes annually and in 2012 it will be $50000. Also, a base contribution rate increase for funding valuation has being introduced through a 10.4% assumed future contribution rate on earnings up to CPP limit and an additional 12% above the limit. The board is able now to increase the real rate of return assumption with the sponsor’s adoption of the increased base contribution rate. These three combination changes undertaken in the pension plan has enabled the sponsors to register a balanced funding valuation as shown below (Ontario teacher’s plan 2011). Funding valuation as at 1st January 2011 ($ billions) 2011 filed 2011 preliminary Net assets $107.5 $107.5 Smoothing adjustment $3.3 $3.3 Future basic contribution $33.8 $28.0 Future special contributions $3.8 $5.3 Actuarial assets $148.4 $144.1 Cost of future pensions ($158.4) ($161.3) Conditional indexing adjustment $10.2 n/a Surplus / (deficit) $0.2 ($17.2) If Ontario teacher’s pension plan is put under defined contribution plan, the financial liabilities will be transferred to the participant and the employer responsibility will become minimal. Under this pension plan, the investment results are lower on average but they have a broad distribution of returns while economic saving increases less significantly. PIMCO is a mutual fund investment firm which stands for Pacific Investment Management Company (Gale pg65). The firm is responsible for a huge investment on behalf of numerous clients who range from retirement savers, foundations and endowments, education institutions, pension plans and central banks. Defined contribution benefit pension plan under PIMCO is carried out in a target date fund criteria whereby the portfolios rebalance automatically as the expected investor’s date approaches through a process known as glide path. Glide path process is an approach that changes asset allocation in a pool of risky assets and lowers risky assets over a time period. Once the pension plan is transferred to PIMCO, the defined contribution benefit will be referred to glide path model whereby the target fund will shift from high risky equity allocation initially to high fixed income investments as we approach the target date (Sass and Munnell pg 210). This approach is highly recommendable because young teachers under this plan will have adequate time to recover from market down cycles. Also, the young teacher’s large amount of human capital he/ she possesses will benefit him during the time of markets decline in increasing personal savings rate. The teachers have advantage under this system because they have the chance of earning high percentage on expected return premium over an investment career for holding the high equity allocation. Even as the target date glide path reduces the equity allocation slowly over time, a considerable equity allocation is held by target date funds as the teachers’ retirement age approaches. The longevity time the teachers are currently experiencing after retirement will be an added advantage under this scheme. This is because, the extensive time under retirement will allow for time to recover from market down cycles being experienced in the current period (Smith and Noonan pg 175). Assuming that the expected equity return premium are to be realized, the portfolio will have high value that will help in mitigating the risk of a reduced income in the long run. Reference Dorfman, M and Rajkumar, S. Governance and investment of public pension assets: a glide path life cycle fund approach. London: Oxford press. 2010. Gale, W. The evolving pension system: trends, effects and proposal for reforms. Boston: Brooking institution press. 2005. Sass, S and Munnell, A. Working longer: the solution to the retirement income challenge. Boston: Brookings institution press. 2008. Smith, M and Noonan, T. Someday rich. Planning for sustainable tomorrows today. New York: Wiley publishers. 2008. Smith, M and Collie, B. The retirement plan solution: the reinvention of defined contribution. California: Telso publishers. 2009. Ontario teachers plan. Leading the way: 2011 annual report. 2011. Read More