Many countries have created funds for their citizens and residents to provide income when they retire or in some cases when they become disabled. Normally this requires a payment throughout the citizens working life in order to qualify for a benefit later on (Wikipedia 2013) which is known as pension. "The common use of the term pension is the payments a person receives upon retirement, usually under pre-determined legal and/or contractual terms, a recipient of a retirement pension is known as a pensioner or retiree" (Wikipedia 2013). This is an appropriate system which offers people a special income when they are no longer making a regular income from employment. "A pension created by an employer for the benefit of an employee commonly referred to as occupational or employer pensions which are a forms of deferred compensation usually advantageous to employee and employer for tax reasons" (Wikipedia 2013).
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Regularly arrangement of retirement plans requires the contribution of money from both the employer and employee to deposit in a fund during the employee working period so as to receive defined benefit upon retirement. Retirement plan is classified as defined benefit and defined contribution in accordance with the determination of such benefit. Defined-benefit plan guarantees a certain payment at retirement using a permanent formula which regularly is subject to the employee's salary and the number of years' employees worked. Defined-contribution plan will provide a payment at retirement that will depend upon the amount of money contributed and performance of the investment made.
"In the private sector, defined benefit plans are often funded exclusively by employer contributions, for very small companies with one owner and a handful of younger employees, the business owner generally receive a high percentage of the benefits; in the public sector, defined benefit plans usually require employee contributions" (Wikipedia 2013), normally these benefits depend upon the nature of organization and the policies of organization. "Employers have used defined benefit plan in competitive labor markets to attract and retain skilled employees, defined contribution plans cannot be used to retain long-service workers because their account balances are fully portable once vested so they provide workers no incentive to stay with their current employer" John A. Turner and Genard Hughes (2008). Now a days, these benefits may face shortages or excesses among the amount presently in the investment plans and the total amount of their pension requirements, the employer, the employee or both have to make a contribution but the investment risk can be borne to the employer and also can benefit from surpluses.
2. A PURPOSE STATEMENT:
2.1 Defined-contribution pension schemes becoming more important way of investment.
Defined contribution pension schemes do not involve a prescribed income in retirement; instead they prescribe levels of contribution to the fund prior to retirement. The retirement obtained through a defined-contribution scheme depends upon the growth rate of investment and the pension rates available at the time of retirement.
Defined-contribution pension scheme is a retirement plan in which a fixed sum of income is invested separately every year from the company for the benefit of their employees, to withdraw these funds must be qualify with the plan rules because there are restrictions to withdraw before due time and should be subject with the penalties. "This is a plan in which contributions are specified (voluntary depending on the scheme) but the amount received by the employee on retirement is not fixed, instead it relates to how the funds in the plan have been invested and the return on that investment. The employee normally has the responsibility of deciding how the contributions are invested though investment choices may be limited by the actual pension fund provider" (lexicon.ft.com -2013). Defined contribution pension scheme needs for employee to invest the money into it, together with contribution from employer and provides to an employee accumulated sum on retirement as a pension income.
Defined-benefit plans gained popularity as a result of three primary factors;
a) defined-benefit have a helpful habit for employee to make them afford a better retirement benefit than that employee expects to obtain over other retirement schemes, especially when employees live for a long period of time after retirement.
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b) defined-benefit plans place the investment risks related with market instability to the employer instead of the employee and
c) defined-benefit plans make the employer to be responsible for decision making on investment instead of the employee. But these are an out dated ways of pension plan in which an employer guarantee a definite monthly benefit on retirement that a formula is predetermined based on the employee's historical income, career of service and age rather than relying directly on individual investment returns. "It is defined in the sense that the formula for computing the employer's and employee's contributions is known in advance but benefit to be paid out is not known in advance" (Wikipedia 2013) .
"The most common type of formula used is based on the employee's terminal earnings (final salary); under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker's career" (Wikipedia 2013). For example, a pension may be set of 1/80th of final salary (let's say £100,000) for every year worked for the employer, so if worker had been employed for 40 years' service, the annual pension benefit would be:
1/80 x £100,000 x 40 = £50,000.
"Members of defined-benefit occupational pension schemes usually have to wait until the 'normal retirement age' of the scheme (typically 60 or 65) before drawing the pension. If a member wishes to draw a pension earlier, there would usually be an actuarial reduction of around 5% per year for early retirement. For example retirement at 55, when the normal retirement age is 60 would entail a reduction in the annual pension of about 25%. Although there are actuarial reductions for retirement before the normal retirement age, there are not usually actuarial enhancements for retirement after the normal retirement age". Keith Redhead (2008).
"Over the past 20 years, there has been a significant shift in retirement plan schemes from the traditional defined-benefit plan to the more contemporary defined-contribution plan; as a result of this change, the primary responsibility for preparing for retirement has been removed from employer plan sponsors and placed upon employees" (investopedia 2010). Shifting investment and durability risks to employees, it may also shift pension costs to employees and away from employers. The switch from Defined-Benefit to Defined-Contribution may lead to the following factors:
"Defined-benefit pensions are extremely expensive on the employer which is why most companies are switched to a defined contribution plan instead; the biggest risk with having a non-government defined benefit plan is that there is the possibility of the pension not being funded properly; this scheme only allow a portion of the pension to be transferred to a spouse if the beneficiary passes away whereas an RRSP is more flexible where all assets can be transferred" (milliondollarjourney 2009). "The demand and supply factors contributing to the shift from Defined-Benefit to Defined-Contribution plan using data on pension coverage for 40 industries, many of the factors they examine and find to be statistically and economically important to the shift in pension coverage relate to increases in the mobility of workers between employers and in-and-out of the labor force. On the demand side, demographic trend in the labor force may have made the risk of Defined benefit plans a more important consideration for workers" (Aaronson and Coronado (2005)).
Many employees they have habit of changing working station over period of time and this may lead to lose some of their working benefits in terms of defined benefit scheme from previous jobs to new jobs. "Workers who anticipate changing jobs before retirement favor defined contribution plans because they suffer a portability loss when they change jobs with a defined benefit plan that they do not suffer in defined contribution plans. They suffer a portability loss when their benefits at retirement are based on their nominal earnings at job change is eroded by inflation that occurs between that date and the date of first benefit receipt". John A. Turner (2008).
Generally, women take a large number of populations worldwide compared to men; even in working environment women have large number of recruitment even if their working morality is low in terms of responsibility and convincement from their belongings. Aaronson and Coronado (2005) emphasis that, "The greater numbers of women in the labor force may be a factor in the reduced demand for defined benefit plans, women may have less attachment to a particular employer than men because they have greater responsibility for care-giving, also they are more likely to be influenced by job changes of their husband than the reverse because they tend to have lower salaries than their husband, though the tendency is declining. Furthermore, the increase in the percentage of the workforce that is dual earner families may reduce the job attachment to a particular employer for both men and women".
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The maximum understandable cause of risk to an employee in the Defined-Contribution plan is the investment performance of the fund. Though, this cause of uncertainty can be controlled by the periodic contributions that could be used to buy deferred annuities which could make retirement income streams same as those delivered by Defined-Contribution plans. Otherwise, it is possible for the plan to choose an investment approach with low adjustment rates of actual returns. "There are however no strong a priori reasons to believe that most individuals would choose to invest accumulated Defined-Contribution funds in the lowest risk asset. Defined-Contribution plans typically offer sufficient flexibility to select a risk-return strategy suited to the employee's individual preferences and circumstances. In construct, Defined-Benefit plans force individual to accumulate the pension portion of retirement saving in the form of deferred life annuities and thus limit the risk-return choice". Zvi Bodie at el (1998).
"A defined contribution pension plan has a fixed contribution usually based as a percentage of the employee's salary the benefit is dependent on how the investment performs with no guarantees as to how much income you will receive during retirement"(milliondollarjourney 2009). "A defined-contribution plan has the benefit of total control over the money/portfolio, the investor can choose various funds and asset allocation within the plan; the scheme watches your money/portfolio grow, what you see is what you get and it control over your money and investments within the plan" (milliondollarjourney 2009). On other hand, the retirement income is entirely dependent on how the investments performs over the vested period so even the employee who has no interested in finances needs to be involved with the investments. "However, evidence indicates that many people struggle to understand and deal with the choices they face when saving for retirement. This is consistent with the principles of behavioral economics, which suggest individuals often do not make decisions in the rational, well-informed, and unbiased manner assumed by standard". Alistair Byrne (2007).
In particular the original belief was that, defined- contribution plans would automatically dominate defined- benefit plans because of the flexibility of defined- contribution plan design. This should be guessed that, anything that could be accomplished with a defined- benefit plan could be duplicated in a skillfully created defined- contribution plan. Defined contribution is very observable since it is always completely funded and the employer normally has no financial obligation other than to make periodic payments into the plan in relation to a defined benefit plan, the accounting treatment is very simple since the payment to defined contribution plan are treated as any other business expenses. So this plan provides relaxation to employees knowing that even they going to change their job from one place to another the benefit is there as long as contribution is made.
Even though , an employee does not have a choice whether to join up in a defined benefit plan or a defined contribution plan, it is usually depending on the company's policy; defined-contribution plans are becoming more common as they are much less risk to the company and possibly to the employee as well.
Aaronson, Stephanie and Coronado, Julia. "Are Firms or Workers Behind the Switch Away from Defined Benefit Pension Plans?" Federal Reserve Board, Finance and Economics Discussion Series, February 2005.
Diamond, Peter, and James Mirrlees (1985). Insurance aspects of pension. In Pensions, Labor and Individual choice, edited by David Wise. Chicago: University of Chicago Press.
John A. Turner and Gerard Hughes (April 2008), A pension Policy Consultant and Visiting Professor, School of Business, Trinity College Dublin. "Large Declines in Defined Benefit Plans are not Inevitable". The Pension Institute Cass Business School-City University 106 Bunhill Row London.
Personal Finance and Investments Book, "A Behavioral Finance Perspective" By Keith Redhead (2008).
Zvi Bodie, Alan J. Marcus, and Bobert C. Merton (1988), "Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-off?" University of Chicago Press. ISBN: 0-226-06285-6.
http://www.milliondollarjourney.com/defined-benefit-pension-vs-defined-contribution-pension-htm "Defined Benefit Pension vs Defined Contribution Pension" by Frugal Trader. January 25, 2013.
http://www.investopedia.com/articles/retirement/10/demise-defined-benefit-plan.asp The "Defined-benefit Plan's Many Problem". January 30, 2013.
http://en.wikipedia.org/wiki/pension "Defined Benefit Plan". February 2, 2013.
http://lexicon.ft.com/Term?term=defined-contribution-pension-plan "Defined-Contribution Pension Plan" The Financial Times LTD. February 5, 2013.