Advantages of Defined Contribution Plans
The past couple of decades has seen tectonic shifts in the way pension plans are being funded. Investors all over the world have been encouraged to shift from defined benefit pension plans to defined contribution pension plans. In the past, defined contribution plans were not considered to be pension plans at all. Instead, defined contribution plans were considered to be supplementary savings plans. Hence, it has been difficult to convince investors about the need to move on to defined contribution plans.
In this article, we will have a closer look at the various pros and cons of defined contribution plans as well as the various ways in which they affect the average worker.
- Allows Employees to Become More Mobile: Defined benefit plans were linked to a particular employer. Hence, employees would only obtain benefits if they continued to stay with the same employer for an extended period of time. Hence, employees were influenced to work at lower wages in order to obtain pension benefits.
However, the modern employee is more mobile. They do not want to work in the same company for a significant amount of time. Instead, they want to change employers frequently so that they can be paid competitive wages.
Defined contribution plans are not employer-specific. Whenever a person leaves an organization, they can simply take their retirement benefits to the new employer. There are some barriers like vesting schedules which may impact the amount of pension which is transferred to the new employer. However, for the most part, defined contribution plans have much more mobility.
- No Burden on Taxpayers: The government has also been encouraging more investments in defined contribution plans. This is because such plans pass on the risk of investing from the taxpayers to the employees themselves. Earlier, the government was partially responsible for providing a certain amount to employees after their retirement. If there was a shortfall in such an amount, it had to be borne by the employers and if the employers failed to do so it had to be borne by the taxpayers.
However, the defined contribution plans are market-linked. Hence, the investor is himself/herself responsible for the performance of such plans. The taxpayer is not bound to pay for the shortfall in any circumstances.
- Not Affected by Underfunding: Another criticism of the defined benefit plan was that such plans were highly underfunded This meant that the government was not setting aside enough money to pay retirement benefits. Instead, they were using the pension funds like a Ponzi scheme. The government was taking control over the amount of money that was flowing into the plan and spending it. The benefits were not paid out of previous investments. Instead, they were being paid out of a new investment.
The problem with this approach is that the birth rate is falling in most countries. Hence, newer employees would have to pay higher contributions to enable payments to older beneficiaries. The defined contribution plan invests the money paid in by employees and pays out the proceeds of the same. Hence, it is not affected by government underfunding.
- Disciplined Investing: Lastly, defined contribution plans increase discipline amongst employees. They are encouraged to set aside a fixed percentage of their income every month for retirement purposes. Such disciplined investing allows investors to take advantage of the compounding process. Even small investments can yield big benefits in the long run.
- Several Investment Options: Defined benefit pension plans were characterized by the one size fits all approach. This meant that the investment policy was created at a company-wide level.
In most cases, the investment policy would be the same across all participating employees. This meant that old, as well as young employees, invested their money in the same manner. Since companies wanted to be conservative, this generally meant that a large portion of the money was invested in low-yield instruments which were considered to be very safe. The end result of this exercise was that the rate of return owned by pension funds was very low.
Defined contribution pension plans have changed this situation. Such plans give individuals the choice to decide on their asset classes based on their risk appetite. Defined contribution pension plans allow investors to decide their asset allocation on a yearly basis. Hence, employees who are young can choose to invest more in equities whereas older employees can choose a more balanced portfolio. This allocation can also be changed every year based on market conditions as well as changing the financial needs of the employees.
The end result of this freedom and choice is that investors have a chance to earn a higher yield on their investments. Also since pension funds are held for very long, the law of compounding drastically increases the overall corpus even if the annual yield is increased by a couple of percentage points.
The bottom line is that a defined contribution pension plan has many advantages. If properly utilized, it can help employees create a much bigger retirement corpus as compared to defined benefit contribution plans.
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