How to choose the appropriate pension plan

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A pension plan is an asset pool that accumulates over working years and is paid out during nonworking years. Choosing the appropriate pension plan for your retirement can be a very complicated decision because of the wide variety of plans available to an individual and also the distinctive needs and attributes of different individuals. "Retirement income is an extremely important component of every individual's life cycle" (David Blake, 2000). The main sources of retirement income are state owned (unfunded) pension schemes or funded pension schemes. The financial and the economic crisis in the recent past have made pensioners doubt the ability of the pension funds to keep their end of the bargain to the mark. All these factors have led to a global debate on which type of pension scheme would be the most efficient.

There are unfunded and funded pension schemes. Unfunded schemes are state owned and also referred to as pay as you go (PAYG) schemes. In PAYG schemes, retired individuals would receive their pensions from the contributions made by the working population. Funded pension schemes can be divided into two types of schemes: Defined Benefit Schemes and Defined Contribution Schemes. Defined Benefit Scheme is one in which the employer guarantees a monthly payment to the employee after his retirement. These monthly payments are calculated using a formula based on age, earnings and tenure of service . Defined contribution pension schemes are private usually and use the contributions of individuals to buy a pool of assets which provides income through appreciation in value for the retirement of these individuals. In this pension scheme, individuals would have to make specific annual contributions through an individual account. The benefits are based on the amounts added to these accounts through employers and sometimes, employee contributions plus the investment earnings on these accumulated amounts. In this report I am going to elaborate on the different types of pension schemes available, discuss the advantages and disadvantages of each as well as the risks associated with each and conclude by suggesting the appropriate scheme for your needs.

The government's role in pension provisions is a monitoring role. It tries to avoid as many discrepancies as possible. The government intervention is used to keep control over : uncertainty of age at death, income redistribution , low savings at retirement and transfer of risk to insurance companies.

The Pension Scheme you have been offered by the hospital is a Pay As You Go (PAYG) pension scheme. "A PAYG pension scheme is a public sector scheme in which taxes are raised in order to fund the transfer of purchasing power to pensioners. The right to receive a pension is essentially a political right, the terms of which are guaranteed by the state - though this is not to say that the state might not subsequently alter the terms on which pensions are offered." (John Eatwell, The Anatomy Of The Pension Crisis,1999). For a PAYG scheme to run successfully the state needs sufficient people working and making sufficient contributions. PAYG schemes have a downward trend since the last couple of years especially in UK and the rest of Europe. This is because people are living longer due to medical advancements plus the population growth rates have been dropping. The labour productivity is not covering up for the shortfall caused by the declining population growth. There is a risk that the younger generation would not be able to generate enough contributions to suffice the older generation. But there are a few advantages of the PAYG Pension schemes. The simplicity of the structure and the transparency in its functioning is evident. The working population makes contributions through taxes. These contributions are used to provide the retired population with a decent standard of living. There is a significant difference in the administration costs involved in a PAYG scheme as compared to a funded pension scheme. PAYG schemes have lower costs than funded schemes. For the pension holder there is a relatively smaller amount of risk involved in a PAYG scheme. But there is a possibility of the government defaulting. They also have a wide coverage. Almost the full population is covered by the scheme. A significant disadvantage of PAYG schemes is the perceived budgetary burden it places on the government and also the resistance to raising necessary funds through taxes. Individual who holds a PAYG scheme would not be able to avail the investor earnings that Defined Contribution scheme holders receive. This is because the defined contribution schemes are funds which invest the pension holders contributions to buy a pool of assets. Also, it is not easy to shift from a PAYG scheme unlike defined contribution schemes which are portable in nature. If the rate of growth of the economy is lower than expected then the rate of growth of pensions may need a reduction. This can create a lot of political problems. PAYG scheme holders have restricted choices when it comes to selecting a scheme which suits their needs unlike defined contribution and defined benefit schemes.

Heather has recently entered a defined benefit scheme (funded pension scheme) with her employer which is a private company. Most of the defined benefit schemes are organised by private companies and are also known as occupational final salary. In such a scheme the employer will assure Heather a specified monthly benefit in her retirement which is calculated based on tenure of service, earnings history and age. "A typical scheme in the United Kingdom has a benefit formula of one-sixtieth of final salary for each year of service up to a maximum of 40 years' service, implying a maximum pension in retirement of two-thirds of final salary, and with the pension indexed to inflation up to a maximum of 5% per annum." (David Blake, 2000). For example, if the final salary of Heather is £60,000 then she would get a pension of £40,000 a year excluding inflation. Defined benefit schemes offer the scheme holder a guaranteed income replacement ratio when she retires. This ensures Heather a standard of living which is close to the standard of living she previously had. But this only occurs only if Heather would not change her job. But as Heather usually keeps switching jobs, she may have to bear massive portability losses. This is because each defined benefit scheme is operated and managed by the employer. If Heather changes her job she would have to shift to another employer's pension scheme. This leads to 2 options. She can either take a transfer value which is the cash equivalent of the accrued benefits, or she can leave it as a deferred pension in the scheme she is leaving. Accrued benefits reduce in value when one changes jobs. According to David Blake, a typical worker in UK who changes his/her job six times has a portability loss which is 25% to 30% of the final pension. One other advantage of defined benefit scheme is the lack of responsibility. Heather will not have to deposit her own money in regular intervals unlike defined contribution schemes.

Defined contribution schemes are funded pension schemes which have a defined contribution rate into the fund. Today majority of the pension plans fall under this category. The holder has to credit the fund with these amounts after regular intervals. The contributions received from all the scheme holders are then invested. The holder would receive the lump sum amount plus investment earnings at retirement. The holder would have to buy an annuity with this amount which would direct monthly payments to him/her. Defined contribution schemes have the most portability of jobs from all the different types of pension schemes. One can also avail tax benefits on the contributions in some schemes. There are chances of earning a higher income compared to defined benefit schemes and PAYG schemes as it involves investments made by professionals in the field. Another important advantage is the tiered investment programme. The holder's money would be invested in high risk vehicles first and gradually shift to low risk investments as the retirement age comes closer. This would mean that the fund has growth potential and can provide investment security. But though defined contribution schemes have a significant amount of portability, it involves administration costs. Individual defined contribution schemes have way higher costs than occupational defined benefit scheme. "The Institute of Actuaries has estimated that all these costs are equivalent to a reduction in contributions of between 10 and 20%; in contrast, the equivalent costs of running an occupational scheme work out to between 5 and 7% of annual contributions"(David Blake, 2000). Defined contribution schemes high risk involved. This is due to the nature of its investments. The capital markets can be unpredictable. The pension holder does not have any control over the investments of the fund.

There are some risks associated with unfunded and funded pension schemes which you or Heather may have to face. PAYG pension schemes have the least risk involved as the pensions would not be given to the holders only if the government goes default. In UK and many other countries the population growth has a downward trend to it. Also medical advancements have led to people living longer. This results in a demographic time bomb which means that there is an inter-generational risk that the younger generation may not be enough to contribute to the pensioners. "In 1990, there was one pensioner in the United Kingdom for every four workers. By 2030, there is projected to be nearly two pensioners for every five workers." (World bank,1994). Funded pension schemes can give the pension holder an illusion of security although there are political risks involved with a large portfolio of financial assets. For example, the Chancellor of the Exchequer had removed the right of pension funds to recover the advance corporation tax. Individually funded schemes also have other risks such as ill-health, disability or death. These risks are not easy to hedge using insurance.

Induced early retirement is one of the problems created by PAYG schemes. These schemes encourage the workers to retire early. Each country has different disincentives to encourage people to stop working. The appropriate solution for this would be to make the retirement age higher. This way the pension holders would be obligated to work for more years. Declining fertility rates and population ageing is another problem which has led to major deficits in state pensions. In many of the European countries the fertility rates are below replacement levels. "Ehrlich and Kim (2007) show, using data from 57 countries between 1960 and 1992, that higher pensions taxes have a negative and significant effect on total fertility rates in all plausible regression specifications".(Booth et al,2008).

I will conclude by saying that you should make a choice after careful consideration into which one would best suit your needs. As a nurse working in a hospital, you would not be changing your job too often. So I would suggest a defined benefit scheme. But even a change in the job once will lead to a portability loss of 16-17% under a defined benefit scheme. This would be a substantial amount therefore defined contribution scheme maybe the most appropriate choice for you.


The trading day started at 9 a.m. and ended at 4 p.m. on the 9th November 2010. My assignment was to sell 1000 units on that day and was supposed to make a profit on the realized as well as unrealized profit and loss account. I could not manage to reach my target fully.

On 9th November at 10:00:02 am the labour union of Global Airlines (GA) threatened their employers with a peak season strike commencing at midnight on that day, because of which the GA had to face tough financial issues. In correspondence to the news, the price of the stocks faced a steady fall as seen in fig 1.1. The correlation of the news and the price fluctuations in the market can also be observed through the change in price of the stocks after the news telecast of the government banning strikes was out at 11:00:11 am. The prices of the stock faced a steady increase. The more the workers, the more is the production, thus resulting in more profit and consequently an increase of the price of the stocks. The selling price was increasing but the buying price was increasing at a much higher rate as compared to that of the selling price of the stocks.

The court then at 13:53:20 pm on the 9th of November ruled the case in favour of the labour union and resulting in the beginning of the labour strikes. This affected the price of the stocks a lot. The selling price of the stocks came to a level after which it did not rise up because there were fewer workers (higher the number of workers, higher is the pensions therefore higher is the profit. This resulted in creating problems for the pension company to generate enough cash to make a profit.

Arbitrators were appointed by the court to settle the disputes between the labour union and the management and to every one's surprise the dispute was settled by agreement of both the parties on the terms set forth by the arbitrators and a new three year contract was signed in affect from that day. This finally resulted in the increase of the selling price of per unit stock from £21.10 to £21.40.

I did manage to sell around 1000 units. But the only problem was my net position remained only negative 204. Some of the details are:

1)Volume - 4864

2)Cash - 3986