Governmental Role in Pension Regulation:
The Government role in pension regulation is primarily to safeguard the interest of the pensioners. The government seeks to monitor aspects which create risks and monetary losses for the pensioner at the age wherein they are vulnerable. The Government intervenes to keep a check on the following aspects:
Risk transfer involved in the process to Insurance companies.
Uncertainty of age of death
Pension fraudulent practices. (aaron 1996)
PAYG: Pay As You Go (PAYG) is a pension scheme which is essentially funded or contributed by the current working population for the retired ex-employees. This pension scheme is the bases for financing most of the state pension schemes. PAYG becomes highly effective when there is a large working populace. The technicality needed for consideration of the effectiveness of this scheme is the percentile growth rate in the combined sum of working population and labor productivity. It is essential that he country's wage bill should exceed the nation's pension bill. (crafts 1996)
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Risks: Since Amy is working in the United Kingdom, note should be taken of the fact that in recent times there is a rising declination in the working population of the country and with advancement in medical sciences the life expectancy is highly increasing. There is an imbalance in the ratio of working populace and the retired populace leading to a situation well described in technical economic jargon as the "Demographic Time bomb". There is the existing threat or risk which cannot be eliminated which is lack of sufficiency of working population to help fund the PAYG scheme for the ever growing number of retired pensioners. (breyer 1993)
The U.K. has until date avoided the "Demographic Time Bomb" by bring about a balance. To fund the PAYG scheme, there has been retail price inflation strategies adopted instead of wage inflation and to a certain extent the nation has been successful. But in other European nations the ratio is in the negative wherein the pensioners have outnumbered the working population consequently resulting in the PAYG scheme failing.
Funded Scheme: The next best parallel option is the funded scheme wherein the threat to the unfunded scheme or the PAYG scheme fails to exist. Currently the funded scheme is primarily in the Public Sector but is expected to be employed in the private sector too. It has been observed by economist such as (Aaron 1996) that over a longer period of time, funded scheme would turn out be more effective than unfunded schemes especially In the United Kingdom where the assets have real rate of return which is higher than the percentile growth rate in wage bill which again corresponds to the percentile return on the PAYG scheme. The Dynamic efficiency of the economy of U.K could result in the funded scheme superseding the unfunded scheme. (blake 1995)
The risks entailed in individually funded schemes are low contribution inflows in the event of unemployment, death during the period of service or employment, bad health conditions, uncertainties associated with asset returns on account of pension funds which are accumulating. These risks result in being expensive or lack the possibility of being overcome by private insurance markets and the pensioners fail to transfer risk efficiently.
In the case of the individual being a low paid employee than the PAYG state run pension scheme presents to be a better option than funded pension as the PAYG system makes provision of a minimum welfare standard through redistribution of income.
Types of Funded Schemes:
Defined Benefit: Under the defined benefit type of funded pension scheme, the pension benefit is stated in all clarity or is rather defined. Here the pension is of a certain proportion of the salary which is dependent on the tenure of service. For the sake of exemplification, in the U.K., a defined benefit scheme would entail 1/6th of the final salary of each year up to a 40 year service period which amounts to a maximum pension of 2/3rd of the final pay packet with maximum of 5% per year on the indexed pension. (burgess 1994)
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However, it must be noted that in Defined Benefit, investment performance of the pension fund does not matter as the pension depend on the final salary of the scheme member and not on the performance of the fund asset. Hence, in the event of the investment asset not performing as desired, the pension amount is not affected as the pension amount hold no relevance to the aspect of investment performance.
Defined Contribution: Here the contribution stands defined such as 10% of the earnings. The pension paid depends on the amount of accumulated funds at the period of retirement. In the U.K. this scheme is known as the Personal Pension Scheme and elsewhere is known as the Money Purchase Scheme. The funds accumulated should be employed to buy a life annuity from insurance companies and in the United Kingdom tax is waved off on 25% of the funds which could be taken out un-taxed by the pensioner.
Under Definite Contribution, Investment performance assumes higher significance. If the pensioner finds himself or herself blocked with inadequately performing assets, then the individual might seek to transfer out to better performing asset which again would entail higher costs and there is the risk of the assets closing down. (Darendorf 1995)
Prior to committing to a pension plan care has to be taken regarding the choice which is made between funded and unfunded pension scheme. It might seem desirable to switch from a unfunded to a funded pension scheme but the pensioner could be confronted with a transitional problematic situation. The problem which could arise is that unfunded pensioners might yet have to be reimbursed and in an unfunded system, the contributions of the working populations are the source. In the event of the introduction of the funded system, the contribution of the working population would be invested and this fund would thereby fail to be available to pay off unfunded scheme pensioners. This deficit which results on transition from an unfunded scheme to a funded scheme by the pensioner is known as a "transition deficit". To subdue or nullify the effect of "Transition Deficit", the Government would have to impose an additional tax or make provision for the issue of recognition bonds. Recognition bonds are understood as an effective form of deferred taxes that provides recognition of liabilities of unfunded schemes such as the PAYG scheme. (BGC 1998)
Furthermore, this would lead to a burden on the next generation of the working population who would end up with the eventuality of paying double fold:
Direct contribution for their pension funds
Additional Taxation for provision of pension for the previous generation of pensioners
The matter stands under debate by economists as to whether future generations would be in acceptance of such a situation wherein they would have to bear the transition deficit effect. Conclusively, the transition from an unfunded pension scheme to a funded pension scheme by the pensioner on realization of the fact that the unfunded pension scheme fails to fulfill the purpose for which it was taken could lead to an undesirable "Transition Deficit" effect and the more of such transition of pensioner from an existing unfunded scheme to a funded scheme could lead to the collapse of the pension scheme. (Chand 1996)
Direct Benefit Schemes: Costs and Benefits:
This scheme presents differing costs and benefits. An definite sum as the title of the scheme suggest is offered to the pensioner who enjoys a similar lifestyle as that prior to retirement and many situations it has been observed that the benefits tend to be on the higher side. But this beneficial situation persists if the worker stays employed with the same enterprise all through his or her working life.
In the U.K., statistics prove that less than 5% of the worker stay with the same enterprise all through their working life. On an average a worker in the United Kingdom changes jobs at least six times through his working life. (blake 1997)
Portability Loss: This occurs every time an employee switches employment and the loss is in terms of the pension. This portability loss takes place as specific employers provide Defined Benefit pension schemes and when an employee quits the job for another, than the employee has to take on the pension scheme provided by the new employer. In the process of doing so , the worker takes cash which is in equivalence to that of the transfer value of the pension benefits which have been accured or a deferred pension is left. The accrued benefits tends to diminish if the person has left the scheme and is higher if the person remains in the scheme. This is on account of the fact that the accrued benefits are valued on the last salary of the worker leaving employment and this last salary tends to be lower.
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In the United Kingdom, portability loss is the most commonly occurring phenomenon and is known as "Cash Equivalent Loss". An approximation of 25%-30% of the full service pension is borne by the pensioner at the period of retirement on account of frequently changing jobs. (abel 1998)
In conclusion, it is suggested that Amy should take in consideration all the aspect of a funded and unfunded pension scheme prior to adoption a pension scheme finally. Since she is in the employment of the health care industry, it is less expected of her to switch jobs like her friend Heather who would have to bear "portability Loss" on account of continuous change of jobs. Amy would be best suited for a Funded Pension Scheme with a Defined Benefit option. This scheme would entail a definite pension benefit irrespective of the level of performance of her pension fund performance. Since she is expected to remain in the health care industry without multiple job switch, "portability loss" would not be experienced by her.
Her second best option would be the Pay As You Go Scheme (PAYG) which offers definite minimum benefits to low paid worker. If Amy is in the category of a low-paid worker in the Health Care Industry then this scheme could be a good consideration. (davis 1985)