Factors Affecting The Decision Of Investing In A Defined Benefit Plan Or Investment Choice Plan

Defined Benefit Plan

The defined benefit plan is a type of the retirement plan under which the benefits payable to the employee are computed on the basis of the various factors such as the employee period, salary paid to the employee in the previous period. The administration of the portfolio management and the risk factor in the investment is being done by the company.

The investment choice plan is the one in which the choice of assets and portfolio in which investment is done is being nominated by the employees. This investment plan gives the option to the employees to get share in the gains and profits that are being earned on the investments. The investment under the investment choice plan can be done by the employees under the four investment strategies which are stable fund, secure fund, trustee’s selection fund, and the shares fund. (Zvi Bodie, Alan J. Marcus & Robert C. Merton, 1988)

All the decisions in regard to investment and the management of the investment is done by the employer which provides that the risk is assumed by the employer in defined benefit plan. The strategies used under investment choice plan are different from each other depending on the characteristics which include the risk and the return. Different strategies are having different level of risk and different level of returns. Thus the payment of retirement under the investment choice plan is dependent on the returns that will be generated by the portfolio that had been made from investment in various assets. (Esther Duflo, Emmaneul Saez, 2002)

Thus both the type of investment plans that is the deferred benefit plan and the investment choice plan are having different characteristics, advantages and disadvantages. The investment plan should be decided on the basis of the requirements and needs of the employees.

Factors affecting decision

The important factors that should be considered by the tertiary sector employees when they are deciding whether to place their superannuation funds in the defined benefit plan or the investment choice plan are as follows:

1. The level and productivity of the assets which is generally determined by the trustees of the Unisuper limited.
2. The length of membership is an important factor in determining the method of investing fund as higher length of membership will give higher value of retirement benefit under the defined benefit plan.
3. The level of risk in investment is a crucial factor as no investment risk is borne by the employees in the tertiary sector and investment risk is borne by employees also.
4. The amount of gains and profits that are earned by the way of trading the asset portfolio as the employees are having no right to get part of gains in defined benefit plans on the other hand, the employees are having right to get the gains under the investment choice plan. (Joshua D. Rauh, 2006)
5. If the employees want to nominate the assets in which their superannuation funds should be invested then they should select the investment choice plan as the employees are having the right to nominate the assets in which there funds should be invested.
6. The amount of retirement benefit under the investment choice plan is dependent on the level of returns that will be generated by the portfolio and the asset combinations hence if the probability of returns is high then the investment choice plan should be preferred but the employees will then have to bear the risk in the investment.
7. Thus, it provides that the level of returns and the risk in the investment is a predetermining factor in the selection of the plan. The defined benefit plans are having less risk thus the level of returns is also low and on the other hand investment choice plan are having proportionately high risk and accordingly the level of returns is also high. Thus these are the most important factors which should be considered by the employees in regard to selection of the type of plans. (CNN Money, 2017)
8. The service fraction is also a crucial factor in the selection of the method of investment as the service fraction is used for calculation in the value of retirement benefit thus it is to be kept in mind that the if the service fraction is high then the defined benefit plan is to be selected.
9. The employees who are having conservative nature should take defined benefit plan as the investment decisions and management of investment is done by the company hence the company is assuming all the risk associated in the investments. Thus the conservative employees are provided fixed returns and if the returns from the investments are less in comparison to the assured returns then the shortfall in the returns is being compensated by the company to the employee.
10. The employees that are having aggressive nature and are having the view of earning higher return then they should choose investment choice plan as they can choose the different investment funds on the basis of the risk and return that is to be possessed by them as the risk is proportionately linked with the returns which means higher risk and higher returns. (Winnie Sun, 2014)
11. The duration of stay in the company is also a important factor as higher period of employment will give high amount of retirement benefit payable to the employee in case of the defined benefit plan and thus the investment choice plan should be not be preferred.
12. The level of inflation is also a very important factor in the selection of the investment plan as if the level of inflation is high then the returns that will be generated by the different investment plans will also be high then the investment choice plan should be preferred.
13. The lifestyle and the living standard of the employees is also a factor which helps in making decisions in regard to the selection of the investment plans as modern lifestyle will demand for the investment choice plans as it may require high returns in order to lead high class life style.
14. The time value of money is also to be considered at the time of making the investment as the net present value to be generated from each investment plan can be compared. (Barbara Friedberg, 2013)

 Concept of time value of money

The concept of the time value of money is very important in the process of decision making. This concept provides that the value of a dollar today is more than the value of dollar that will be received in the future periods. This concept will help in quantifying the returns that will be generated from different investment plans. Thus the returns that will be generated from both defined benefit plan and the investment choice plan will be calculated and then the present value of both the investment plans will be calculated. The present value from each of the plan is to be calculated using an appropriate discount rate. Hence it will take into consideration the potential earning capacity. (Luke Catalli, 2014).

The time value of money takes into consideration the risk factor that is being there in regard to receipt of money from different investment plans. The time value of money will also help in knowing the preference of the employee in regard to different investment plans. Hence the time value of money will help in also taking into consideration the additional cash flows that may be generated from both the superannuation investment plans. This concept will help in comparing the values that will be received by the employees under the different investment plans.

Investment Choice Plan

(Barbara Friedberg, 2013) It will also help in comparing the present value of the cash inflows and cash outflows of the employees. It will facilitate the employee to compare the different plans with the present value or the value that can be received in the equivalent terms today. Hence the time value of money becomes an important aspect in evaluation of the decision in regard to whether the investment should be done in the defined benefit plan or the investment choice plan. (Barbara Friedberg, 2013). The time value of money in regard to the defined benefit plan will help in calculating the present value of the salary benefits in regard to the membership period and the average service fraction.

The discounted and present value will be calculated by discounting the retirement benefits by an appropriate rate of discount. The time value of money in regard to the investment choice plan will help in calculating the present value of the gains that will be received from different portfolio and investments and the charges for administration will accordingly be reduced from the total gains.

The gains will be estimated on the basis of the level of certainty keeping in view the level of risk and level of returns. Thus the employee can compare the net amounts that will be received from both the investment avenues and he can make investment in the avenue in which he will be receiving higher return with a minimum level of risk. Hence it had been proved that the time value of money is a pre-requisite factor in the determination of the decision in regard to that superannuation fund should be invested in the defined benefit plan and the investment choice plan. (Luke Catalli, 2014)

 Efficient market hypothesis

Efficient market hypothesis is a type of investment theory which provides that it is not possible to beat the stock market as the efficiency in the stock market leads to a situation where the present share prices of stock provide all the required and the material information. According to the concept of the efficient market hypothesis, the stocks of different companies are being traded at the fair value of the share on the relevant stock exchange. Hence the efficient market hypothesis does not give opportunity to the investors to purchase the stocks that are undervalued and sell the stocks at a price which is higher than the fair value. Hence this concept makes sure that it is not possible to out-perform the activities of the market by making random selection of the stock. (Trevir Nath, 2015).

Thus, it is not possible for an investor to make profits by just purchasing the low price share and selling them at a higher price. Thus the only way by which the investor can get higher returns and profits is through making investment in the risky projects. The concept of efficient market hypothesis is based on the main assumption of price efficiency. If the market efficiency hypothesis is true, then the returns that can be generated from the stock will be equal to the market return as the price of share will be equal to the fair value of share. ( S. Basu, 1977).

Hence in case of efficient market hypothesis, the pension manager cannot select the portfolio with a pin as the markets cannot behave efficiently which provides that the market price of share cannot be equal to the fair value of the share. If the market value of the share is not equal to the fair value hence there is scope for arbitration and thus the managers can attain profit on purchasing and selling the shares. Thus the pension fund manager cannot just randomly select the portfolio on the basis of the assumption that the stocks are correctly priced and there are various stocks which are under-valued and over-valued. Thus the pension fund manager need to properly evaluate the stocks in regard to their risk and return.

They must select the undervalued stocks in order to purchase then so that profits can be obtained at the time of selling them. High profits can be earned on the undervalued stocks due to increase in prices of share in the market.( Allan Timmermann, Clive W.J. Granger, 2004) Thus the pension fund manager will be able to earn higher return by undertaking moderate risk and also evaluating various different stocks in accordance with their fair values. The stocks that are selected also need to be checked in accordance with the level of risk. The pension fund manager should minimize the risk in the portfolio and also try to maximize the return and he should use the theory of efficient market hypothesis but should not blindly rely on this theory as it is based on price efficiency which keeps on changing. (Sebastian Harder, 2010)

References:

1. Luke Catalli, 2014, “What Time Value of Money is and Why it’s Important”; Available at: https://www.moneygeek.ca/weblog/2014/07/28/what-time-value-money-and-why-its-important/
2. Barbara Friedberg, 2013, “Time Value of Money in Financial Decision Making”; Available at: https://barbarafriedbergpersonalfinance.com/mba-class-time-value-of-money-financial-decision-making/
3. Zvi Bodie, Alan J. Marcus & Robert C. Merton, 1988, “Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-Offs?”; Available at: https://www.nber.org/chapters/c6047.pdf
4. Trevir Nath, 2015, “Investing Basics: What is the Efficient Market Hypothesis and What are its Shortcomings?”; Available at: https://www.nasdaq.com/article/investing-basics-what-is-the-efficient-market-hypothesis-and-what-are-its-shortcomings-cm530860
5. Jonathan Clarke, Tomas Jandik, Gershon Mandelkar, 20xx, “The Efficient Markets Hypothesis”; Available at: https://m.e-m-h.org/ClJM.pdf
6. Basu, 1977, “Investment Performance on Common Stocks in Relation to their Price-Earnings Ratios: A test of the Efficient Market Hypothesis”; Available at: https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1977.tb01979.x/full
7. Allan Timmermann, Clive W.J. Granger, 2004, “Efficient Market Hypothesis and Forecasting”, International Journal of Forecasting, Vol 20, Issue 1, pp. 15-27; Available at: https://www.sciencedirect.com/science/article/pii/S0169207003000128
8. Sebastian Harder, 2010, “The Efficient Market Hypothesis and its Application to Stock Markets”; Available at: https://books.google.co.in/books?id=A-6AN7PHbzAC&dq=efficient+market+hypothesis&source=gbs_navlinks_s
9. James J. Choi, David Laibson, Brigette C. Madrian & Andrew Metrick, 2002, “Defined Contributions Pensions: Plan Rules, Participant Choices, and the Path of Least Resistance”; Available at: https://www.journals.uchicago.edu/doi/abs/10.1086/654750
10. Esther Duflo, Emmaneul Saez, 2002, “Participation and investment decisions in a retirement plan: the influence of colleagues’ choices”; Available at: https://www.sciencedirect.com/science/article/pii/S0047272701000986
11. Joshua D. Rauh, 2006, “Investment and Financing Constraints: Evidence from the funding of Corporate Pension Plans”; Available at:  https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2006.00829.x/full
12. Finn E. Kydhand, Edward C. Prescott, 1977, “Rules Rather than Discretion: The Inconsistency of Optimal Plans”; Available at:  https://www.journals.uchicago.edu/doi/abs/10.1086/260580
13. Andrew Blackman, 2014, “Make Better Business Decisions Using the Time Value of Money”; Avaialble at: https://business.tutsplus.com/articles/make-better-business-decisions-using-the-time-value-of-money–cms-19324
14. CNN Money, 2017, “What are the advantages of a defined benefit plan?”; Available at: https://money.cnn.com/retirement/guide/pensions_basics.moneymag/index9.htm
15. Bennett, Coleman & Co. Ltd., 2017, “Definition of Pension or Annuity Plan”; Available at: https://economictimes.indiatimes.com/definition/pension-or-annuity-plan

Winnie Sun, 2014, “Defined Benefit Plans: The Overbooked Retirement Vehicle For Successful Entrepreneurs”; Available at: https://www.forbes.com/sites/winniesun/2014/01/17/defined-benefit-plans-the-overlooked-retirement-vehicle-for-successful-entrepreneurs/#1dd172a33f9c