Tuesday, October 01, 2013

Defined benefits and defined contribution

These are two major ways in which retirement benefits are received. The nature of the benefits will also impact the way in which the planning process is conducted. The benefits at the time of retirement can come either through defined benefits or the route of defined contributions. Each method has its own characteristics and hence has to be understood and dealt with in their own manner.
The name of the plan suggests its main features. Defined benefit plans are those where the benefit provided to an individual after retirement is known. This means that the route for calculating the benefit is clearly defined at the starting point itself. Any person who becomes eligible for the benefit will be able to make the calculations and arrive at the figure.
These plans are beneficial because here the person knows the exact calculation based upon which the amount will be received. It is the duty of the employer to pay out the required sum at the appropriate time. The onus thus shifts from the receiver to the provider of the benefit. Employees thus would prefer to invest in such plans because they provide them assurance about the amount that they will be receiving at the time of retirement.
a)      It is very easy to recognise a defined benefit.
b)      Certain amount paid to the employee when a specified time period is complete.
c)       There is no necessity of the payout being linked to the amount and kind of investment that is made in the scheme and the plan.
d)      These schemes are a big relief for employees, as they will receive the payout no matter what are the conditions in the market and even if they turn bad the employee is protected. 
e)      The final responsibility of payment lies with employer in these plans.
f)       If there is any shortfall in the amount to be paid out then the employer or the person managing he fund has to make the necessary arrangements to make the payout.

Defined contribution is another method in implementation in this area. The features of this route are different from what the defined benefit method seeks to give. This method is finding increasing acceptance across the world by various companies as well as governments. The basic premise of the defined contribution method is that the onus of retirement planning is on the individual. This means that they take the necessary amount of risk in the entire venture. The starting point is the contribution and there is a defined amount or a specified amount that is contributed to start off the process.
a)      Contribution will be made by the employee or by the employer or by both.
b)      Sum is invested as per the requirements and then the required figure paid out from the earnings of this investment.
c)       The earning of the investment determines the amount that the individual will get from the scheme. If the earnings are less they will get a lesser amount while if it is more then a higher amount is available.
d)      Risk is on the shoulders of the individual. No one else will share the blame and even more important is the fact that there is no amount that is guaranteed anywhere.

Comparison between Defined Benefit Plans and Defined Contribution Plans
Defined Benefit Plans
Defined Contribution Plans
Benefits to be received at the time of retirement are fixed.

There is a definite sum to be received at the end of plan, as benefits.

Suitability in regular /stable earnings.

The characteristics of the plan itself determine the calculation of various benefits.

Gratuity, Leave salary, Voluntary, Retirement schemes, Retrenchment compensation are some examples.
Benefits to be received at the time of retirement are not fixed could be high depending on market conditions.

There is a definite amount of money to be contributed at the start and at various stages of the plan.

Even suitable in uncertain earnings.

The calculation of the benefits depends upon the earning s of the investment.

Employees provident fund (EPF), Public Provident Fund (PPF), Mutual fund schemes, Equity funds, Unit linked plan are some examples.

Employers and Employees Perspective:
Employers and Employees have different perspectives. Employees look for a sure return without much needed investment (Defined benefit Plan) while employers want to have a predetermined liability and want to provide benefits to long term employees (Defined contribution plans).
Defined Benefit Plan: In a defined benefit plan, the benefits available to an individual after retirement are pre determined. Such plans are favoured by employees as benefit can be conveniently calculated. The employee can expect to receive the promised benefit, no matter what the market conditions. The final amount is available to employee as monthly pension or a lump sum. Such plans are favoured by employees because:
a)      It allows an individual to enjoy the same standard of living as he was enjoying before because the final retirement benefit under defined benefit plan is calculated on last drawn salary.
b)      It also provides an employee a reassurance of a known amount of income after retirement.

Defined contribution plans: In these plans the onus of retirement planning is on the employee and he takes the necessary investment risk. Agreed levels of contributions are directed to an individual account. Defined contribution plans have become more widespread and are now the favoured plan of private sector employers because:
a)      Since the employer’s liability towards a defined contribution retirement plan is well defined, it is easier for him to make decisions regarding changes in the remuneration package and is not affected by changes in the economy such as interest rate fluctuations.
b)      There is no need for actuarial valuations and getting approval of the schemes by tax authorities or other regulatory bodies. The assets belonging to each employee can be clearly identified.

Transition from Defined Benefits (DB) to Defined Contribution (DC)
Traditionally the employers followed the concept of fixed pension plans under which employees receive a monthly amount on retirement, guaranteed for his life or joint lives of the members and his/her spouse. The monthly benefit amount is primarily dependent on the employee's wages and the year's of service. Recently, there has been a shift in the trend from "Defined Benefits" to "Defined Contribution". Defined contribution has been a critical mechanism for retirement provision since 1980. The initial proposition of the defined contribution plans is to provide the employees with certain amount of money to meet their healthcare needs, in lieu of which the employees shall purchase health insurance plans. Under defined contribution, the ultimate benefit is based exclusively upon the contributions to, and investment earnings of the plan. The benefit ceases when the account balance is depleted, irrespective of the retiree's age. Although the defined contribution has enabled the employers to clearly define their medical insurance expenses year wise and shift the risk from employers to employees, at the same time it has also gathered various debatable thoughts around it. The most important being- can defined contribution is looked upon as an absolute replacement for defined benefits?
With defined contribution in place, can we forgo the maintenance of defined plans for the current retirees and for the people who have vested years into service? The maintenance of both the plans is definitely an extra cost and burden on the state. In government and public sectors employees generally have lower wages but comparatively high retirement benefits. Transition to DC shall require the employees to have a rise in their wages to become competitive and receive the required benefits. As a result of which a trend of shifting to private sectors will start for higher wages and better opportunities. This would in turn encourage higher attrition rate and loss of senior and highly experienced employees. Another important factor driving the success of the DC plans is the market conditions at the time of retirement. If a person retires when the market is down, returns from the contribution shall lower down which eventually might affect his future investment plans. DC may also lead to adverse selection where in the higher risk and older population will go for generous plan and the younger healthier population will chose for lower contribution schemes. This will lead to inequity and ugly risk pooling. Dc plans run on the amount which has been deposited and earned in the account. It doesn't hold good for people who are disables or lose their lives early in their career as they fail to accumulate sufficient wealth for their family.
Like every coin has two sides, even DC has a brighter side which cannot be ignored. The major advantage with DC plans is portability for workers. As the contributions are made directly into individual account, the workers can take the accumulated wealth with themselves when they change the job. In DB plans the contribution are gathered in a common pool where the worker's share are not properly defined which eventually a hurdle is when the worker plans to change the job. DC plans also offer the employees a transparency regarding the employer's contribution towards their benefits. Unlike DB, DC plans have offered the employees a chance to make their own investments. One can't negate the fact the DC plans have introduced the concept of consumerism in healthcare. With evolution of products like CDHP (Consumer health driven plans) which has enabled the individuals to take the charge of their healthcare decisions. However the ultimate success of these plans depends upon level of education assistance which is imparted prior to implementation and the plan payouts forecasted at the switch date.