Discuss about the Understanding Defined Benefit Plans.
In order to retain the best talent within an organization, employers tend to provide them with certain retirement benefits either through mandatory rules or voluntarily. Some of the retirement benefits include provident fund, National Pension scheme, gratuity etc. Superannuation is also a kind of retirement benefit provided by employers to their employees. Proper planning of superannuation will help employees to plan their retirement in an efficient manner (Clear Tax, 2018). In Australia, the government of the country makes arrangements regarding superannuation so that the people are able to accumulate a certain sum of money for their better retirement (Australian Government, 2018). According to the Australian law, an employer deposits the money in a super account which is maintained under an employee’s name. 9.5 per cent of the employee’s income including all the other incomes like bonuses, commissions, etc. is deposited as superannuation under the employee’s name. This is called as Super Guarantee in Australia (Industry Super Funds, 2018).
This amount is decided by the employees to contribute in different investment models like Defined Benefit Plan and Investment Choice Plan. A detailed description of these two investment models has been discussed below:
Defined benefit plan in simple terms can be understood as an employer sponsored retirement plan which aims to provide benefits to employees at the time of their retirement. This is computed through a specific formula which is based on different factors like length of the employment as well as the salary trend of the employee. In this method, there are restrictions on the time as well as the method selected for withdrawal of funds by the employees (Investopedia, 2018). This plan is called as defined benefit plan because the employees as well as the employers know the formula beforehand for measuring the retirement benefits that an employee is going to enjoy. This plan is different from other pension funds as in this case, the pay-out amount in the end depends upon the returns earned on the investment. If there is a poor return this may result in a shortfall in the total amount and in order to compensate this amount, employers use the organizations earning to balance the amount with the calculated amount (IRS, 2018).
It is seen that defined benefit fund is becoming a rare phenomenon in Australia as majority of the population is moving towards investment choice plans. 10 per cent of the population are the members of defined benefit fund whereas, 90 per cent of the population are members of investment choice plans. Facts reveal that only the elder employees are members of defined benefit funds and nearly all the public sector organizations have stopped to open a new defined benefit fund for their new entering employees (Super Guide, 2018).
Under the Investment Choice Plan, the amount of the pension as well as the value of the retirement benefit is not known to an employee or an employer beforehand. The value of the retirement benefit in this type of plan majorly depends upon the contributions that have been made as well as the returns that have been generated on the investment made. In this type of superannuation, the contribution is either decided by the employee or the employer or in some case by both of them (Economic Times, 2018). Many facts reveal that the pension world has shifted their attention from defined benefit plans to investment choice plans. Australia as well as America is amongst the largest holders of defined contribution assets which is a part of the investment choice plans among the pension funds (Goh, 2016).Australia’s contribution system is looked upon by major world powers and has a lot to teach the other economies. Australia’s investment choice plans offer a wide range of diversity investment strategies, they keep a check on the pitfalls that has the ability to hamper the returns as they come with great coverage, and also the contribution is quite more. Hence, the investment choice plans of Australia are considered to be one of the best at international level (Cohen et al., 2011).
There has been always a contradiction on the matter for deciding over the superannuation type that whether one should go with defined benefit fund or with investment choice plans. The answer to this is that it should be totally based on people’s choice and few other factors like
This has been further explained in the below heading that discusses in detail about the factors that influence the decision related to the selection of the type of superannuation. In the case of defined benefit funds it is believed that persons who do not want to take higher risks as well as are sure that they are going to get a higher hike in their salary in the coming years can go for defined benefit funds. This is so because this will be the best and the safest and surest return on their investment. Though, this statement will be disagreed by employers as, in this type of superannuation, the employers have to pay from the organizations’ revenue for any kind of shortfall because of the fluctuations in the market (Lime, 2012). Defined benefit is the safest option as it has no negative impact of market movements, which is a very general phenomenon these days. Hence, in this type of superannuation, an employee gets the calculated amount even if the market conditions are bad or worse. In short, it can be said that the defined benefit account was started with an aim to provide the employees with a respectable amount at the time of their retirement as a gesture to show them their value as well as to greet them for their service to the organization (QSuper, 2018).
This is not the case with investment choice plans. Investment choice plans are vulnerable to market fluctuations and the direct negative impact of this falls on the employee’s retirement plans. Though, in the case of investment choice plan it can be said that if at the time of the retirement of the employee, if the market condition is good then, the employee can enjoy more from what had been expected by him or her (Investopedia, 2018).
Value for money
One of the major difference in defined benefit plans and investment choices plan is that in the defined benefit plan the employers contribute the whole money whereas, in other investment contribution an employee is required to contribute. May be this is one of the main reasons behind the employers moving towards investment contributions and withdrawing themselves from the idea of defined benefit plan. But from the viewpoint of an employee, if an employee is getting an option to select from defined benefit plan and investment choice plan for superannuation without giving any second thoughts the employee should go for defined benefit plan. The main reason behind this is that defined benefit plan offers the best value for money. The amount invested is not lost as well as if any loss is incurred because of the volatile nature of the market then, the loss is borne by the employer from the organizations earnings and hence, the employee gets what was told to him beforehand (Money, 2014). But, it is also believed that in order to live a comfortable life one should opt for investment choice plans instead of defined benefit plans. The main reason is that in defined benefit plan, the amount is fixed beforehand and as the person receives the amount many years back, the cost of living, inflation rate, and other expenditure cost must be doubled by that time. Hence the speculation that has been made today, in next20 years from now may not be calculated at par. And hence, it is believed that there are chances that people may not be able to live a comfortable life that they have thought of. On the other hand, investment choice plans are driven by market conditions, and hence, there are chances that after 20 years the amount that the employee will get will be according to the then market conditions and hence, will be sufficient for an employee to live a comfortable retirement. But, as it is known that market fluctuates very drastically at times so, there is no surety of the returns that whether it will fulfil what is being expected by it or not. In the case of investment choice plan, the financial risk is borne by an employee (Pension Retirement, 2013).
Time
In case of defined benefit plan, it can be said that if the employee is planning to continue with a specific firm for lifelong then, this option is the best for such employees. But, if the employee is planning to switch from one organization to other in every 3 to 4 years then, such employees should go with the investment choice plans. The preachers of investment choice plans argue that investment choice plans are more secure than defined benefit plans. This is so because, in case of defined benefit plans the pension amount is totally dependent on an employer, and if any employer goes bankrupt than not even a single penny will be received by an employee risking the whole pension which the employee was entitled (Roseman, 2008). The life expectancy also has a major role to play in the decision- making process. In the case of defined benefit plan if the employee lives a longer life then the pressure to arrange pension for longer term is on the employer. Whereas, in the case of investment choice plans, if the employee lives a longer life than he has to think over their spending so that their savings last longer (Career Smart, 2017). Hence, it can be said that, it is a very difficult task to decide over which superannuation option is better,as both have their set of pros and cons.
Taxes
Majority of the investments are done with an intention to get tax benefits through that investment. Superannuation is also a part of an investment plan and hence, tax benefits are enjoyed in this scheme as well. Tax benefits are enjoyed by both the types of superannuation that is defined benefit plan as well as in the investment choice plans. In the case of defined benefit plans, an employer also enjoys tax benefits along with employees and hence, defined benefit plans are considered to give a higher return as compared to the investment choice plans. In the case of defined benefit plan, the employers can deduct the contributed amount whereas the employee need not pay any tax on the amount until he starts receiving the contribution that is probably at the time of the retirement (AXA, 2018).
Conclusion
So, to conclude it can be said that the better option for an employee will be defined benefit plan. Though, it can be recommended that if the employee wishes to get higher returns on his investment and live a comfortable life during retirement then, the employee should go for a combo of defined benefit plan along with investment choice plan. This will provide a wide scope to the employees to earn good return on investment at the time of their retirement. On the basis of the comparison that has been made between the two, the safest and the best option that can be recommended is the defined benefit plan, as a fixed income is expected during the retirement as well as in this type of superannuation, the financial risk is borne by an employer, and so, an employee is free from any kind of burden. So, in short it can be said that defined benefit plan is always better than the investment choice plans if the employee is expecting a fixed income during his retirement and is also planning to serve a single organization for a longer term.
References
Australian Government (2018) Superannuation [online]. Available from: https://www.australia.gov.au/information-and-services/money-and-tax/superannuation [Accessed 17 May 2018].
AXA (2018) Understanding defined benefit plans [online]. Available from: https://us.axa.com/axa-products/retirement-planning/articles/understanding-defined-benefit-plans.html [Accessed 17 May 2018].
Career Smart (2017. Defined Benefit vs. Defined Contribution Pension PLANS [online]. Available from: https://careersmart.org.uk/your-career/pensions/defined-benefit-vs-defined-contribution-pension-plans [Accessed 17 May 2018].
Clear Tax (2018) Superannuation – How it Works, Types and Tax Benefits [online]. Available from: https://cleartax.in/s/superannuation [Accessed 17 May 2018].
Cohen, J., Ezra, D. & Furlan, T. (2011. Australia’s Defined Contribution System: Lessons We Can Learn (and Teach) [online]. Available from: https://www.ifebp.org/inforequest/0161096)pdf [Accessed 17 May 2018].
Economic Times (2018) What is defined contribution retirement plan and how it works [online]. Available from: https://economictimes.indiatimes.com/wealth/invest/what-is-defined-contribution-retirement-plan-and-how-it-works/articleshow/63235897.cms [Accessed 17 May 2018].
Goh, J. (2016) Australia has highest proportion of defined contribution assets [online]. Available from: https://www.moneymanagement.com.au/news/superannuation/australia-has-highest-proportion-defined-contribution-assets [Accessed 17 May 2018].
Industry Super Funds (2018) Super Basics [online]. Available from: https://www.industrysuper.com/understand-super/super-basics/ [Accessed 17 May 2018].
Investopedia (2018) Defined-Benefit Plan [online]. Available from: https://www.investopedia.com/terms/d/definedbenefitpensionplan.asp [Accessed 17 May 2018].
Investopedia (2018) How does a defined benefit pension plan differ from a defined contribution plan? [Online] Available at: https://www.investopedia.com/ask/answers/032415/how-does-defined-benefit-pension-plan-differ-defined-contribution-plan.asp [Accessed 17 May 2018].
IRS (2018) Choosing a Retirement Plan: Defined Benefit Plan [online]. Available from: https://www.irs.gov/retirement-plans/choosing-a-retirement-plan-defined-benefit-plan [Accessed 17 May 2018].
Lime (2012) Defined Benefit versus Defined Contribution [online]. Available from: https://www.limesuper.com.au/single-post/2012/04/10/Defined-Benefit-versus-Defined-Contribution [Accessed 17 May 2018].
Money (2014) What Is the Difference Between a Defined Benefit Plan and a Defined Contribution Plan? [Online] Available at: https://time.com/money/2791222/difference-between-defined-benefit-plan-and-defined-contribution-plan/ [Accessed 17 May 2018].
Pension Retirement (2013) Which is better? Defined Contribution vs. Defined Benefit Pensions [online]. Available from: https://pensionretirement.com/which-is-better-defined-contribution-vs-defined-benefit-pensions/ [Accessed 17 May 2018].
QSuper (2018) Defined Benefit account [online]. Available from: https://qsuper.qld.gov.au/our-products/superannuation/defined-benefit-account [Accessed 17 May 2018].
Roseman, E. (2008) What’s best: defined benefit or defined contribution plan? [Online] Available at: https://www.thestar.com/life/parent/2008/01/27/whats_best_defined_benefit_or_defined_contribution_plan.html [Accessed 17 May 2018].
Super Guide (2018) Defined benefit funds [online]. Available from: https://www.superguide.com.au/superannuation-topics/defined-benefit-fund [Accessed 17 May 2018].
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