Important Factors To Consider When Choosing Between Defined Benefit Plan And Investment Choice Plan For Superannuation Contributions In The Tertiary Sector

Defined Benefit Plan

What do you think are the important factors that should be considered by tertiary sector employees when they are deciding whether to place their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan? What issues relating to the concept of the time value of money, taxes etc., might be important in this decision-making process? Explain.

The tertiary sector has nowadays become the biggest constituent of a country’s economy. Such as in a developed economy like that of UK, it comprises of almost 80 percent of the GDP and an equally same ratio of employment as well. In the past century, there has been a shift from a manufacturing based economy to a service sector economy. Tersiarisation comprises of the service sector contributing to comprise of the largest chunk of the economy. The employees belonging to this sector receive various benefits and contributions from their employers such as in the form of provident fund and superannuation contributions. Superannuation is an organizational pension plan which is formed by a corporate for the advantage of its staff members, a sort of a retirement benefit plan and the funds are decided to be invested in some of the plans available such as the defined benefit plan and the investment choice plan. The concentration on superannuation and persuading people to save and invest for their future, specifically their retirement years has been impressed upon in the last 20 years in Australia too. One of the biggest development in the superannuation funds management and service provisions in the present day has been a major increase in the kind of superannuation fund products and investments and retirement plan options, wherein the members presently have lot more suppleness in choosing between the kind of funds and assets their superannuation contributions are put in. In line with the enhancing investments choice, two forms of superannuation plans are being discussed i.e. a defined benefit plan and investment choice plan (Tejvan, 2016). There are various factors which has to be considered while deciding upon whether the superannuation funds should be put into a defined benefit plan or the investment choice plan. The said essay details about each of the plans specifying the various issues which should be taken into consideration such as time value of money, taxes etc before deciding upon the same.

Various researches have been carried out in the past with regards the defined benefit plan and it has been construed that the said plan is the one which gives benefit to its staff members at the time of retirement and the benefit is computed basis a formula which takes into account various factors such as the employees final average salary, age and the years of service in the organisation. The retirement benefit is computed by the below mentioned formula:

Investment Choice Plan

Retirement benefit= Benefit salary * lump sum factor* average service fraction* length of membership.

The defined benefit plan has been one of the most prevalent plans due to various factors. Firstly, the particular plan entails to provide the employees with a greater retirement advantage than what they would have received via the other available retirement schemes, specifically if the employees are healthy enough to be able to live for a longer duration post retirement. Secondly and one of the most crucial is that the defined benefit plan puts the investment risks attached with the volatility in the markets upon the employer and not the employee (us.axa.com, 2018). Thirdly, the since market fluctuation risk is on the employer, therefore the investment related decisions are also a responsibility of the employer and not the employee. Lastly, companies generally have a larger time perspective than the life expectancy of the employee which makes it clear that the employers have a greater appetite to take up the huge volatile conditions of the market over various market cycles (Adkins, 2010).

Further many employees want a monthly amount as their pension with the help of which they expect to spend their life easily, for such employees the said plan is said to be the best as the defined benefit plan enables monthly pension payment scheme (Erez, 2016). Thus these factors are what makes the defined benefit plan lucrative for an employee.

Another plan available to them is the investment choice plan which is basically a member investment choice plan thereby it gives an option to a super fund member to have a power to speak with regards where he would want his funds to be invested in. Being a part of the super fund, the member has the option to select which asset class to invest in. There are various factors that are required to be considered with this kind of superannuation fund investment too This kind of a plan is a risky one as the employee is responsible for his decision and hence the risk appetite of the investor plays a crucial role. Secondly the investment time frame i.e. for what time frame will the super fund remain invested. Whether the employee is nearing retirement or has just started with the investment. Lastly what does the employee expect to gain financially in future.

Contributions from both the employee and the employer are tax deductible and the gains that occur are free from taxes, thus the retirement account of an employee is totally financed by definition but the firm has no ultimate accountability but for contributing an agreed sum periodically. Thus the valuation of the investment choice plan is simple as it ensures measurement of the market value of the assets which is held at the time of retirement. Here the tangible size of the retirement annuity will be reliant upon the realised investment feat of the retirement fund, the interest rate at retirement and the final wage path of the employee (Murphy et.al. 2014).

Factors And Issues To Be Considered While Deciding Between The Defined Benefit Plan And The Investment Choice Plan

Since both the plans are well discussed, it is critical to make a decision as to which plan is more suitable and beneficial for the tertiary sector employees, the defined benefit plan or the investment choice plan. Various factors discussed above as well as issues such as tax related and time values of money are to be taken into account before arriving at a conclusion.

Firstly, as is aid the investment choice plan is by nature a fully funded plan, which connotes that the market value of the plan’s assets are equivalent to the responsibility of the sponsor to the plan’s beneficiaries. However, in contradiction to the same, the defined benefit plans funding means are complicated by nature. Here even if the plan’s assets are put into securities which are listed wherein the market value is easy to determine, the problem is measuring the responsibility level of the sponsor.

Further as is mentioned the investment choice plan is more risky as compared to the defined benefit plan. The most sought after risk with regards the former plan is how the money in traded securities perform, thereby making it an uncertain selection. But the same be curbed to some extent such as the periodic payments of the investment choice plan may fundamentally be utilised to buy deferred annuities which would enable generation of retirement income streams which is equivalent to those offered by defined benefit plan also. The investment choice plan as the name says provides ample flexibility to chose between a risk-return tactics which is best suited to the employee’s personal choices and situations. Whereas in contradiction to the same, the defined benefit plan compels people to accrue the part of he pension of retirement saving in the form of deferred life annuities and thereby restricts the risk return preferences.

For employees, the tax related issues with each of the above plan are fundamentally the same. Employees are not required to pay taxes on the contributions made by the employers, investment gains or the capital gains derived from these retirement plan assets until and unless these benefits are received by them. But those employees who are a part of the defined benefit plan have to pay taxes on their personal plan contributions in the year the said income was earned. Mostly the private sector defined benefit plans do not ask for the contributions from the staff members but the public sectors do. Thus under both the plans the gains are subject to tax when the income is received by the employee. The outcome of the tax is reliant on the form of benefit payment and not on the kind of plan chosen (ebri.org, 2005).

Nowadays inflation is a major issue across the globe. Thus when it comes to inflation, the defined benefit plan is flawed. Under the said plan the benefits will be available to the employees who terminate their employment much before their retirement are not indexed for inflation which is happening between the date of termination and the retirement date. Thereby those employees who start and end their career with one employer only are most benefitted than those who keep on switching jobs. Another issue to be considered is that inflation post retirement can wash away the value of the accumulated pension benefits.  Especially this is an issue for the investment choice plan whereas the defined benefit plan in the public sector give routine increment in the benefits paid to the retirees.

Lastly, another major issue or factor to be considered is that the investment choice plan is fully funded whereas the defined benefit plan is underfunded. Under the latter plan, although the employees have the right to future gains as they work, however the employer does not always totally fund the accumulating pension burdens. On the other hand, the former plan is never underfunded as here the employer also has to be an obligatory contribution which is known and can be part of the budget of the company (Forman, 1999).

Conclusion

Thus although both the plans have advantages and disadvantages attached to it, it becomes difficult to be dependent on any one kind of the plan. The defined benefit plan is basically for those kind of employees who do not want to take much risk whereas the investment choice plan is basically for those kind of employees who want to take a risk and expect greater returns. The defined benefit plan is an age old plan which is not beneficial for those employees who keep on rotating from one job to another and is also not fully funded by the employer. Thus whatever be the plan adopted for the investment of the superannuation funds, the ultimate aim should be to provide maximum benefits to the retirees and their spouses throughout the span of their retirement era.

Although, the defined benefit plan is a more conservative kind of a plan which mainly ensures that the employees are getting a fixed amount during their retirement years even if the same is not funded fully but has security and the entire burden is on the sponsor since the maintenance of the fund is their issue, yet the investment choice plan being new is more attractive for the present day employees. Employees who believe in taking risks and demanding for higher returns chose the said plan as they can easily switch over investment plans and gain better at par with the inflation as well at times. Sticking to one plan is a difficult ask as both the plans have their own pros and cons. It all depends upon the risk appetite and the tax consequence as well.

References:

Adkins,T., (2010), The Defined- Benefit Plan’s Many Problems, Available at https://www.investopedia.com/articles/retirement/10/demise-defined-benefit-plan.asp (Accessed on 21st May 2018)

ebri.org, (2005), Defined Benefit and Defined Contribution Plans: Understanding the Differences, Available at https://www.ebri.org/pdf/publications/books/fundamentals/fund05.pdf (Accessed on 21st May 2018)

Erez,M., (2016), Choosing between a Defined Benefit Pension Plan and Commuted Value, Available at https://www.odlumbrown.com/documents/Content-Docs/ClientFinancialPlanning/Tax/ChoosingBetweenDefinedPensionPlansAndCommutedValue.pdf (Accessed on 21st may 2018)

Forman,J.B., (1999), Public Pensions : Choosing Between Defined Benefit and Defined Contribution Plan, Available at https://jay.law.ou.edu/faculty/jforman/Opeds/msu-publicpension.pdf (Accessed on 21st May 2018)

Tejvan, (2016), Tertiary –Service Sector of the economy, Available at https://www.economicshelp.org/tertiary-service-sector/ (Accessed on 21^st May 2018)

us.axa.com., (2018), Understanding defined benefit plans, Available at https://us.axa.com/axa-products/retirement-planning/articles/understanding-defined-benefit-plans.html (Accessed on 21st May 2018)

Murphy, M.C., Gerrans,P., & Speelman,C., (2014), What Drives Individuals’ Superannuation Investment Choices? Preliminary Evidence on Return Chasing, Available at https://www.researchgate.net/publication/267417585_What_Drives_Individuals’_Superannuation_Investment_Choices_Preliminary_Evidence_on_Return_Chasing (Accessed on 21st May 2018)