Discuss about the Corporate Finance Benefit Plan.
In last few decades, the importance of superannuation and investment for old age has been increased in Australia. The Australian government is also emphasizing giving on this matter. The government has made it mandatory to contribute the minimum amount to comply with the retirement funds or superannuation on behalf of the employees by their respective employers. Owing to this compulsory contribution towards the superannuation fund, huge amount of money is flowing into the fund and the fund’s role in turn is to invest the amount profitably and generate sufficient income for the employees at the retirement age (Unisuper.com.au 2017).
One of the largest superannuation fund in the tertiary sector of Australia is Unisuper Limited, that includes TAFE colleges, Universities and institutions of higher educations. Unisuper offers two types of plans for superannuation:
Defined benefit plan is the plan for retirement for the contribution of employer, where the benefits of employees are calculated with consideration with things related to the salary history and employment length of the particular employee. The company manages the risk and return for the investment. Restrictions are there for withdrawing the fund without paying penalties. These plans are known as the qualified benefit plan or pension plan as the method of calculation is used to know the contribution is ahead of time. This fund is not same as the other retirement fund, where the return depends on the payout of the invested fund. Therefore, if the required returns fall short of invested amount, then the employer must make up for the difference. As the employer is answerable for taking decisions about investment and managing the investment, he presumes all the risks related to the investment (Lin et al. 2014, pp. 68-86).
Retirement earnings under this plan are calculated based on the formula. The formula for calculating defined benefit plan is:
Retirement Benefit = Length of membership x salary benefit x average service fraction x Lump-sum factor
The above formula can offer for a set amount for every year of employment or specific earning percentage. The benefit can also be calculated using the average earnings of the employee during the past few years of service (Brown, Emily and Medeiros 2014).
Most of the defined benefit plans permit to select according to the choice of the employees that how they want their benefits to be paid. Generally, the following payment options are offered:
Single life annuity: Under this method the beneficiary receives a fixed benefit per month until his death. After his death, the survivors do not get any benefit
Lump-sum payment: Under this plan, the entire amount is paid in lump-sum payment. However, no further payment is made to the beneficiary or his survivors.
Qualified survivor and joint annuity: Under this plan the the beneficiary gets monthly benefit until his death. After his death, his surviving spouse will receive the benefit on continuous basis, until his or her death.
Selecting the right benefit plan is very crucial as the amount to be received after retirement depends on the selection of plan (Blake,Wright and Zhang 2014, pp.105-124).
Advantages of defined benefit plan:
A defined benefit plan focuses on the actual benefit that is to be paid out. The employer commits to pay the employee a certain amount at the time of retirement and the employer is answerable for ensuring the fact that sufficient funds are there in the fund to pay out the required amount at retirement, even if the investment portfolio does not perform as per the expectation (Munnell, Aubry and Crawford 2015, pp. 15-21).
The employees who prefer the investment choice plan, they maintain an individual account for investment inclusive of personal contribution to superannuation, contribution by employer and annual segregation of profit earned on their contribution less any payment paid as management and distribution charges (Agnew 2013). Under this plan, the employees have the option of nominating the categories of portfolios or assets in which their contributions are to be invested among the following four strategies:
The reward for taking risk, while investing, is the probability of getting higher return. If the investor has long term plan for his investment, then he can earn high return with careful planning. High risk involved investment options like Bonds, stocks can be opted for long-term goals. On the contrary, choosing only cash as investment option is perfect for meeting short-term goals (Nguyen,Gallery and Newton 2016, pp. 3-22).
Considering appropriate mix for investment:
An investor can protect himself against considerable losses through investing in various categories of assets. If one category of asset performs well, then another category perform in average or poor depending upon the condition of the market. Allocation of asset has great impact on meeting the financial goal. To get sufficient return from investment, the investor must include some high-risk associated investments (Fischer 2013).
The time value of money is a crucial factor to all the investors as the value of a dollar today is more than the value of a dollar in future. The surplus dollar available in hand today can be invested and capital gains or interest can be earned on that dollar. A dollar, which is promised to be paid in future, is actually less valuable than the dollar available in hand today. Present value and future value are calculated as follows:
Present value = (Expected future cash flows)/(1+ Rate of return)Number of periods
Future value = Present value x (1+ Rate of return)Number of periods
Under the defined benefit plan, the expected future benefit is calculated based on the formula. The formula takes into consideration the average salary of the employee, age, length of service. Time value of money is crucial for defined benefit plan as it calculates the future expected benefit of investment. Each person has some future targets in terms of financial goals. Once the targets are recognized, the targets are required to be converted into financial terms. To achieve the targets, the investor must have clear idea about the time value of money (Schmidt 2016).
Under the investment choice plan, the investors are able to get return after a specified time based on his selection of investment portfolio. The investor can choose the plan as per his requirement and preference with consideration to his return expectation and risk tolerance level. The expected return cannot be calculated until the future value is calculated using the time value formula. Therefore, time value is crucial for both the defined benefit plan and investment choice plan.
Under the defined benefit plan, the final benefit is calculated solely based on the formula. Therefore, no scopes are there for the performance of the portfolio. The employees from tertiary education, who selected to invest in defined benefit plan, their superannuation investment is invested in the assets solely decided by Unisuper Limited. The risk involved in the investment is solely borne by the company and the employees are not benefitted from any extra gain of the investment. On the other hand, under the investment choice plan, the investors himself has to bear the risk involved in the investment and at the same time he is eligible to get benefitted from the return achieved from the investment. Therefore, it is rightly said that, the investors who opted for defined benefit plan is sacrificing the potential gain from the investment earning and returns created in association with time value of money (Mpakaniye and Paul 2014).
At the retirement time, Unisuper Limited offers a wide range of options for defined benefit plans as well as investment choice plan to the investors to allocate and manage their retirement benefits. These option are as follows:
Indexed pensions: It offers a regular earning that is catalogued to inflation and are payable till the death of the beneficiary and after his death it is paid to his surviving spouse and she or he will receive the benefit on continuous basis, until his or her death.
Single life indexed pensions: Under this method the beneficiary receives higher earning as compared to the standard indexed plan benefit per month until his death. However, the benefit is not transferrable to his survivors after his death.
Allocated pensions: It offers a continuous earning at the required level and can have access to the investor’s capital and various investment options in which the money can be invested. The balance benefits are allocated to the survivors after the death of the beneficiary.
Roll-over options: Roll over takes place when the funds are reinvested from a matured security into a new security. The investor can opt for roll over or transfer his balance retirement fund to any other approved industry or personal investment or superannuation fund, retirement savings account or any approved deposit fund. This option is undertaken primarily to earn money for any particular purpose, for example, saving of taxes or daily trading. The benefits from roll-over varies with the various investment (Turner and Klein 2014, pp 42-54)
Distribution of part-cash: A specific part of the retirement fund limited to the tax and regulatory approvals, can be withdrawn in lump sum amount that is to be utilized for personal consumption or investment purpose.
As per the time value of money, the surplus fund available in hand today can be invested and capital gains or interest can be earned on that find. A dollar, which is promised to be paid in future is actually less valuable than the dollar available in hand today (Kashyap 2014, pp.106-110). With consideration to time value of money, from the above options, the best option of investment is the Roll-Over Option as the option involves investment in the long term bonds and switching over the balance fund to any other approved industry or personal investment or superannuation fund which has better prospect for return. The reasons of selecting this option for investment are:
Example of Roll-over investment with regard to time value of money:
$10,000 is to be invested for 5 years and the investment will earn 7.25% per annum compounded annually. The future value of the investment will be:
Future value = Present value x (1+ Rate of return)Number of periods
= $10,000 x (1.0725)5
= $14,190 approximately (Farrell 2016).
Now, if the investor wants to earn $10,000 out of this amount at the return rate of 6.50% per annum compounded annually after 3 years, then the amount required to be invested today is calculated as follows:
Present value = (Expected future cash flows)/(1+ Rate of return)Number of periods
= $10,000/(1.0650)3
= $8,280 approximately.
Therefore, out of the received amount of $14,190, the investor can keep ($14,890 – $8,280) = $6,610 and invest $8,280 at the return rate of 6.50% per annum to receive $10,000 after three years. Thus, the Roll-Over option of investment is most attractive for the investor (Mpakaniye and Paul 2014).
Reference:
Agnew, J., 2013. Australia’s retirement system: Strengths, weaknesses, and reforms. Center for Retirement Research Issue Brief, pp.13-5.
Blake, D., Wright, D. and Zhang, Y., 2014. Age-dependent investing: Optimal funding and investment strategies in defined contribution pension plans when members are rational life cycle financial planners. Journal of Economic Dynamics and Control, 38, pp.105-124.
Brown, J.D., Emily, G. and Medeiros, J.D., 2014. Understanding the Differences Between Defined Benefit Pension And Defined Contribution.
Farrell, B., 2016. Depreciation and the Time Value of Money. arXiv preprint arXiv:1605.00080.
Fischer, G., 2013. Investment choice and inflation uncertainty.
Kashyap, A., 2014. Capital Allocating Decisions: Time Value of Money. Asian Journal of Management, 5(1), pp.106-110.
Kristjanpoller, W.D. and Olson, J.E., 2015. The effect of financial knowledge and demographic variables on passive and active investment in Chile’s pension plan. Journal of Pension Economics and Finance, 14(03), pp.293-314.
Lin, Y., Tan, K.S., Tian, R. and Yu, J., 2014. Downside risk management of a defined benefit plan considering longevity basis risk. North American Actuarial Journal, 18(1), pp.68-86.
Mpakaniye, D. and Paul, J., 2014. Time Value of Money. Time Value of Money (December 17, 2014).
Munnell, A.H., Aubry, J.P. and Crawford, C.V., 2015. Investment returns: Defined benefit vs. defined contribution plans. Issue In Brief, (15-21).
Nguyen, L., Gallery, G. and Newton, C., 2016. The Influence of Financial Risk Tolerance on Investment Decision-Making in a Financial Advice Context. Australasian Accounting, Business and Finance Journal, 10(3), pp.3-22.
Schmidt, C.E., 2016. A Journey Through Time: From The Present Value To The Future Value And Back Or: Retirement Planning: A Comprehensible Application Of The Time Value Of Money Concept. Browser Download This Paper.
Turner, J.A. and Klein, B.W., 2014. Retirement Savings Flows and Financial Advice: Should You Roll Over Your 401 (k) Plan?. Benefits Quarterly, 30(4), pp.42-54.
Unisuper.com.au. (2017). UniSuper Home Page. [online] Available at: https://www.unisuper.com.au/ [Accessed 13 Jan. 2017].
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