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Pension is regular payment made by the state to people of or above the official retirement age and to some widows and disable people. It can also be defined as a regular payment made during a person's retirement from an investment fund to which that person or their employers has contributed during their working life. (Concise Oxford dictionary, 10th edition). In addition to that pension can be viewed as retirement account that an employer maintains to give an employee a fixed payout when he/she retires. This payout depends mainly on how long the employee worked for his/her employer and on salary. On retirement, the retiree may choose between a lump sum payout or monthly annuity payment. There are two types of pension's schemes. These defined benefit pensions scheme and defined contributions pensions' scheme.
Defined benefit scheme are those in which the employer commits to provide specific benefits related to an individual's wages and length of employment (International Monetary Fund, 2004). In defined contribution pension scheme, workers accrue funds in individual accounts administered by the sponsor. The contributions of employees are typically deducted directly from their pay and frequently some portion of these contributions is matched by the employer. (Broadbent, J., Palumbo, M. and Woodman, E., December 2006)
In preparing personal finance, retirement being the central topic, a lot of question stem as to the difference between these two schemes. It has been observed that defined benefit plan is losing its dominance in occupational pension system in many countries. This essay will uncover the distinguished features between these two schemes and reasons behind defined contributions pension scheme becoming more important in occupational pensions system. The scope of the essay will focus in detail to the differences between these two schemes .The distinguished features between these two are as outlined below:
Payout in monetary terms
Risks (Market risk)
Contribution formula (Calculating formula)
Payout transferability (Next kins eligibility to the pension)
Cash equivalent loss or portability loss
Also it will focus in detail to the reasons for defined contributions scheme becoming more important in occupational pensions systems which are:
Increased mobility of labor
Increased cost of defined benefit plan
Lower Administrative costs
Change in the industry composition of employment
Regulatory and tax changes
Familiarity with stock market
Longevity of life expectancy
Volatility of contributions
The discussion take off by explaining in details the distinguished features between defined benefit scheme and defined contributions pension scheme.
Under defined benefit scheme, the payout is fixed to a certain formula at the time the retiree is collecting his/her pensions. The formula is combination of years of service multiplied by percentage of average salary during the last years of service. In defined contributions scheme the payout depend mainly on the employee salary and how the portfolio performs but no guarantee as to how much income the retiree will receive.
Another major difference between these two scheme is risks especially market risk. Market risk is the whereby the value of investment changes. In defined benefit scheme, market risk depends mainly on performance of the economy of the country concerned. In an economy which is growing and asset value increasing, the cost of funding pensions by the employer decreases as the rising values of the investment enables the company to contribute less and still build the value of the plan to cover the future pension's obligations. On the other side, when the value of assets decreases and decline in market, the employer is going to inject more money into the scheme to settle the future obligations. Also market performance does not affect the retirees since he/she will continue to receive the same amount each month. The market conditions mainly have the impact on the employer side as is forced to pump more money into the plan from current revenue thus increasing its cost at the expense of its profit when market decline. When market rise, the employer is benefited as it reduces its pension's contributions. In defined contributions pension scheme, reward and risks are reversed. The retiree may reap most of the benefits and at the same time my assume most of the risks. At the time of economic growth, the retirees may see their wealth and income increases along with investment values.
With defined benefit scheme, it is commonly based on certain formula linked to an employee's wages or salary and years of tenure at the sponsoring firm. In defined contributions pensions' scheme, the contributions of employee's are typically deducted directly from their pay and frequently some portion of these contributions is matched by employer (Broadbent, J., Palumbo, M. and Woodman, E. December 2006)
The Payout transferability.
In defined benefit scheme, it only allows the portion to be transferred to the spouse of beneficiary. In defined contributions pension scheme, the pension income can be transferred to the beneficiary wholly.
The Portability loss or cash equivalent.
In defined benefit pension scheme, every time workers switch jobs they experience a "portability loss" in respect of their pensions entitlement. This is because, defined benefit schemes are generally provided by specific employers and when workers changes job they have to move to a new employer's scheme. When they do so, they will either take the transfer value equal to the cash equivalents of their accrued pension's benefits with them or leave a deferred pension in the scheme that they are leaving. Accrued benefits are valued less favorably if someone leaves t a scheme than if they remain an active member of the scheme. This is because, scheme leavers (whether they choose a transfer value or deferred pensions) have their years of services valued in terms of their leaving salary where as continuing members will have the same years of services as the early leaver valued in terms of their projected salary at retirement which is likely to be higher. Long stayers are therefore subsidized at the expense of early leavers. (Blake, D., 2000). Defined contributions pensions schemes have the advantages of complete portability when switching from one employer to another.
After looking at the distinguished features between defined benefit pensions scheme and defined contributions pensions scheme, attention is given to the reasons behind defined contributions pension scheme becoming more important.
Increased mobility of labor.
Nowadays it is difficult to find the employee working with the same company for a long time. Employees switch from one to another more often. So in order for them to avoid the loss by switching from one job to another for their pensions entitlement (portability loss), they prefer defined contributions pensions scheme as it is relatively advantageous. This is due to the fact that benefits in this scheme accrue evenly throughout their working life should the worker switch from sponsoring firm or leaves the job.
Defined benefit scheme is the better deal for the employee since he/she will receive the same shillings despite the market conditions. On the other side of the coin, this pension scheme is very costly to the employer. Defined benefit plans are contracts in which the expected present value of wages and pensions payments must be at least equal to the expected present values of wages a worker can earn in the spot market(Broadbent, J., Palumbo, M. and Woodman, E. December 2006). But defined contributions pension plan are less costly to employers than defined benefit contribution pensions scheme as these makes defined contributions scheme to become more important.
As more and more workers retires and begin to collect retirement benefits, the employer have to devote more and more resources to pay for those promised benefits. Before long they were crippled by enormous payments they had to fund the pensions plan. This led most employers to shift to defined contributions pension scheme (http:www.savingmoneytoday.net/2011)
Most small and medium size employers prefer defined contributions pension scheme due to adverse experiences, an aging population pressure and competition for elite labor.
Defined benefit plan are very complicated and costly. Therefore, most employers and employees prefer defined contributions pensions scheme as for employer it is easier to administer and for employee it is easier to understand the benefits they will get.
Lower administrative cost.
Administrative cost under defined benefit scheme tend o be higher compared to defined contributions scheme which makes most of employer prefer defined contributions scheme.
Under defined contributions, members have more personal control and investment options. This led to the growth of defined contributions pensions' scheme.
Change in the industry composition of employment.
Many of the largest defined benefit plans have been in manufacturing industry such as steel and auto productions, and in other heavily unionized industries. As these industries have declined, the prevalence of defined benefit plans has also diminished because of high mobility of labor shifting to better pension's scheme. (Broadbent, J., Palumbo, M. and Woodman, E. December 2006).
Regulatory and tax changes.
The defined benefit scheme become increasingly costly and complex to administer due to the fact that they are governed by rules contained in pensions legislation, regulation, and tax policy. These tax and regulatory restrictions have reduced the incentive for firms to sponsor defined benefit plans, by increasing the cost of administering the plans and by limiting firms' flexibility in providing benefits. (Broadbent, J., Palumbo, M. and Woodman, E. December 2006). These factors tend to make most employers to turn into defined contributions pensions' schemes.
Increased familiarity with the stock market.
Nowadays there has been increased awareness of stock market investing among workers. Rising of equity prices have led to the rapid growth of defined contributions plans in most countries. Despite the decline of global equity market between 2000 and 2002, most workers still have become increasingly interested in pumping their retirement savings through defined contributions pensions' scheme.
Both the increase in life expectancy and the unexpectedly large size of the increase have been cited as reasons for the decline in defined benefit plans in many countries. The increase in life expectancy means that a larger asset base is needed to provide the same level of benefits over the longer retirement period. The effect of this change can be large. Employers bear the cost of increases in life expectancy, and they bear the risk of unexpected increases in life expectancy. (Turner J.A and Gerard H, April 2008). Example, if the retiree was expected to spend 12 years in retirement but it happens he spends 20 years, it means the additional 8 years of retirement must be funded. This makes defined contributions pensions scheme to become more important.
Employers find it desirable to use defined contributions pensions scheme because of volatility and unpredictability of contributions under defined benefit scheme. This increased contributions Volatility and unpredictability may have been due to regulations and accounting rules. An aspect of contribution volatility is the length of time that employers have to amortize an unfunded liability. Employers need to be given sufficient time to deal with the fluctuations in unfunded liability so that they do not face an excessive level of volatility of contributions. . (Turner J.A and Gerard H, April 2008).
Increase in reporting requirement, changes in legal requirements and administrative burden under defined benefit scheme increase compliance cost which is fixed. Also another additional cost is actuarial valuations which are required under defined benefit plan. All these burden of cost induce most of the employer to prefer defined contributions pensions scheme as all these cost are not required for defined contributions pension scheme.
Under defined contributions pensions scheme, if the employee leaves the job and want to withdrawal from the scheme, he/she will be fully be paid accordingly that's why most employee find defined contributions more important.
Conclusively, the explanations described above shows the distinguished features between defined benefit scheme and defined contributions which are payout to the retiree, market risk, contributions formula, transferability of payout and portability loss. Also included in is explanations on the reasons for defined contributions scheme becoming more important which are labor mobility, increased cost of defined benefit plan, sustainability, risk, simplicity, lower administrative cost of defined contributions pensions scheme, its flexibility, change in the industry composition of employment, regulations and tax changes, familiarity with stock market, longevity of the retiree, contributions volatility, no compliance cost and termination incentives. It is worth pointing that, these two schemes may have names which are similar but they have got differences as to what they mean to the retiree. Also for defined contributions plan to become important, mainly the major cause could be because of decline of defined benefit scheme. However, there are situations where by the defined benefit scheme are beneficiary to both employer and employee.