The Chinese Pension System
February 12, 2025
In the previous article, we have already studied what bank guarantees are and how these bank guarantees are provided by a commercial bank as a value-added service to their corporate customers. We are also aware of the various types of bank guarantees as well as their purposes. In this article, we will understand some of […]
The financial world has not witnessed much innovation since the 2008 meltdown. This is because any innovation in this sector is scrutinized for possible systemic risks. However, during this period peer to peer lending has evolved. The industry is still in a pretty infant stage. However, in 2015, peer to peer credit accounted for over […]
The past decade has seen a rapid increase in the number of start-ups. There are more companies which start up every year now as compared to a decade earlier! As a result, there are numerous new kinds of players which have come into existence in the start-up universe. One such type of company is called […]
When a firm declares bankruptcy, this decision has an impact on all the contracts signed by the firm. The law forces the firm to complete its performance in case of some contracts. On the other hand, the firm has the option to opt-out of some contracts. One such category of contracts is called employment contracts. […]
A couple of years ago India as a country, was facing a huge divide. The government of India had passed a new legislation which would allow foreign direct investment into the retail sector. This meant that global economic giants like Wal-Mart, Tesco and Sears were on their way to open up stores in India. Needless […]
Defined contribution plans have come under a lot of criticism because of the various disadvantages that they have. Many of these plans have been viewed as a covert way to absolve the government of any responsibility related to the retirement of its citizens.
Given the many other socio-economic factors which are at play, defined contribution plans are viewed as having replaced the assurance of a pension plan with the uncertain vagaries of the market.
In the previous article, we have seen how the world has moved from defined benefit pension plans to defined contribution pension plans. We have also seen why private entities all across the globe have been supportive of this change. Their willingness to quickly implement this change has led to a situation wherein more than three-quarters of pensions in the world are based on defined contribution plans.
There are serious drawbacks to defined contribution plans. Such drawbacks warrant a detailed discussion. In this article, we will discuss some of the common disadvantages which are associated with defined contribution pension plans.
A defined contribution pension plan works by passing on the market risk to the employee. Hence, the company is merely a trustee which contributes a given sum of money to the markets on behalf of the employee. The employee bears complete responsibility for market risks. Hence, if the retirement corpus of the employee becomes very low because of market conditions, then the company is not liable to pay the difference. On the flip side, if the employee is able to generate phenomenal returns in the market, they are entitled to keep those returns too.
The problem with this arrangement is that financial markets can be quite risky. Since people who retire do not have any other sources of income, many experts consider their exposure to financial markets as being excessively risky.
In many cases, pension funds tend to be inefficient. Hence, their expenses tend to be higher than average mutual fund. Since pension investments are held over very long periods of time, the difference of a few percentage points can make a huge difference to the corpus.
There are many industries such as the tech industry where there is an implicit preference for having a younger employee on board. If not outright unemployment, underemployment is also common in many industries. Due to high unemployment people have to take jobs which they are overqualified for.
If a large number of people are unemployed or underemployed, their pension contributions tend to be inadequate. This is very different from defined benefit pension plans where stable employment was a given.
In other words, the real income of the employees tends to do go down with time.
Over time, this translates to a smaller percentage of the salary being channeled towards defined contribution pension plans. Smaller monetary inputs in the scheme finally lead to a situation wherein the final corpus is also smaller than required.
Hence, defined contribution plans always bear the risk that the employee may live to an age where they either run out of their corpus money or the money that they receive on a monthly basis has very little value thanks to high inflation rates.
It is also important to note that the cost of medical treatment has been spiralling out of control over the years. Also since medical expenses are a big part of the overall expense of the retirees, the inflation rate for retirees tends to be much higher than the average inflation rate.
Hence, the pension amount which may seem significant in the early years of retirement may quickly become insufficient in the later years.
The bottom line is that defined contribution pension plans have some serious disadvantages if the employee is not disciplined with their contributions. Also, the onus of risk-taking and choosing the asset class falls on the employee who may not be able to make the best decisions.
Companies are happy to implement defined contribution pension plans since they only have to act as a trustee. They are not liable to pay a fixed amount to the employee regardless of market conditions.
Your email address will not be published. Required fields are marked *