Collective Pension Schemes

In the previous few articles, we have learned about the various types of pension schemes. We have also learned that these pension schemes are of two types viz. defined benefit scheme and the defined contribution scheme.

Over the years, the number of defined benefit schemes in the market has reduced drastically. This means that most of the schemes present in the world today are defined contribution schemes.

Traditionally defined contribution schemes, as well as defined benefit schemes, are individual pension schemes. There is another type of scheme called the collective pension scheme.

In this article, we will have a closer look at the concept of collective pension schemes. We will also try to understand the various characteristic features of such schemes.

What are Collective Pension Schemes?

Collective pension schemes can be best understood by comparing them with individual pension schemes. In an individual pension scheme, the money is invested into individual accounts. The value of each individual account is different. However, when it comes to collective pensions, such individual accounts do not exist.

All members invest their money in a common pool of funds. This pool of funds is then managed and invested by the fund management company.

Collective pension schemes are only successful if there are a large number of employees. Such schemes do not work well for hundreds or thousands of employees. Instead, they work when tens of thousands of workers are involved. In certain parts of the world, entire industries are being covered as a part of collective pension schemes.

Collective pension schemes are considered to be halfway between defined contribution schemes as well as defined benefit schemes. The pension received from a collective pension scheme does not completely depend upon the individual’s considerations. Also, there is a target value that collective pension schemes plan to pay out. This target pension value is not a contractual obligation.

Instead, pension funds try to achieve this on a best effort basis. However, based on empirical evidence, collective pension schemes have been able to pay out 30% more as compared to defined contribution schemes.

Advantages of Collective Pension Schemes

Collective pension schemes have become extremely popular because they have several advantages. The details of some of these advantages are mentioned below:

1. Risks are Spread Out: The first and the most obvious advantage of a collective pension scheme is that it spreads out the risk between young workers as well as retirees.

   The collective pension scheme is basically a mechanism that allows for the intra-generational transfer of risks. This risk transfer mechanism allows for the risks to be distributed between people who have more income-generating years left and the ones who are dependent upon retirement income.

2. Less Susceptible to Market Value: As mentioned above, the amount of pension paid out by collective pension schemes is not 100% dependent upon the market conditions. In a particular year, if the market is down, the pension fund may cut down the target pay out rate or it may increase the contribution by the younger employees.

   Collective pension schemes make an attempt to cushion the blows of the market and provide a stable income during retirement.

3. Risk Not Borne by Employers: The risk transfer happens between employees of different generations. As a result, the employers are not at all impacted by the shortfalls or increases in pension funds. This means that the solvency of the employer is not at risk because of the vagaries of the market. It is for this reason that many employers actively advocate the adoption of collective pension schemes.

Disadvantages of Collective Pension Schemes

Collective pension schemes also have several disadvantages. Many of these disadvantages have been mentioned below:

1. Pay-outs are Not Guaranteed: It is important to understand that the target pay-outs are only indicative. The pension fund is in no way making a promise to make these pay-outs regardless of market conditions.

   It is important to note that these pay-outs have been cut down in the past due to bad market conditions and are likely to be cut down again in the future if the market faces a major collapse.

2. Cannot Choose Portfolio Asset Mix: One of the benefits of having a defined contribution plan is that investors can choose their own asset mix based on their own risk appetite.

   Young investors can choose to remain highly invested in equities whereas old investors can choose a more conservative portfolio. Since collective pensions are not managed at an account level, individuals do not have the freedom to choose their own portfolio mix. Hence, the return on investment for these portfolios is also not under their control. Collective pensions are considered to be good only for risk-averse investors.

3. Unpredictable Payments: Both the inflow of cash into the pension fund and the outflow of cash from it is unpredictable. The retirees can have their target pension amount reduced. At the same time, the younger generation can have their contributions increased. The end result is that there is sometimes no parity between the amount contributed and the amount received. Often it ends up being a game of luck wherein risks and losses get unevenly distributed.

4. Less Regulation: Also, since collective pension funds are relatively new, they are not regulated as extensively. This means that collective pension funds can invest more in alternative investments and also charge a higher fund management fee. All of these actions have the capability to lower the earnings of the fund.

5. Lower Returns: Traditionally, collective pension schemes have shied away from equity. They tend to invest their money in very long-term bonds. This is the reason that their returns tend to be lower than defined contribution schemes which invest heavily in equity stocks. Since equity pays more than any other investment class in the long run, collective pension schemes tend to have lower returns.

The fact of the matter is that collective pension schemes are still relatively new. They have been adopted in certain parts of the world. However, large-scale adoption of such schemes has still not been completed.

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