How do Pension Plans Work?

The main objective of the financial system is to allow the participants to meet their financial goals. One common goal which almost every financial system participant has is the goal of a comfortable retirement. Most people want to set aside certain sums of money in their productive years and invest this money wisely so that it can provide for them in their later years when they are unable to earn. This is accomplished through pension plans. In simple words, pension plans take cash flow in installments now, invest this money, and provide cash flow in installments. Depending upon the nature of the plan, these cash flows continue until the death of the beneficiary and their dependents. Some pension plans provide an option between a regular monthly income or a lumpsum payout.

Pension plans, therefore, form an important part of the financial system. In this article, we will have a closer look at what pension plans are and how they operate.

What are Pension Plans?

A pension fund is a collective pool of funds where employees contribute a fixed amount periodically. This amount is proportionate to the salary of the employee and increases with an increase in their salary. Also, the amount contributed is generally made up of two parts. One part is contributed by the employee. At the same time, another part is contributed by the employer. The minimum amount of money which is has to be contributed by the employer changes as per the jurisdiction of the pension fund. However, in most parts of the world, their contribution has to be equal to or greater than the employee contribution.

The pension contribution is often determined by a complex formula. This formula may use the total number of years of service as well as the number of years of service with the same employer as inputs.

Defined Benefit Vs. Defined Contribution

Defined benefit pension plans are when employers guarantee a sum of money that each employee will receive during retirement. Since the employer provides the guarantee, it also faces the risk that the rate of return provided by the fund may not be enough to reach the guaranteed amount. In such cases, the employer may have to shell out more money later on in order to ensure that the employee receives their due share. From the employee's point of view, they face almost no risk. The only risk that they face is that the employer might go out of business. Such risks are also covered by regulatory agencies in return for a fee. Defined benefit plans are rare these days. Only public sector employees in some parts of the world still have a defined pension plan.

Defined contribution plans are the exact opposite of defined benefit plans. In these plans, the responsibility of the employer ends when they make their contribution. The risk of the performance of the fund is borne completely by the employee. These plans are market-linked and, therefore, also tend to provide higher returns. Most private-sector employees around the world have defined contribution plans.

Pension Funds Vs. Mutual Funds

Pension plans can be said to be like mutual funds in the sense that they pool resources and appoint a specialized manager to invest them. However, pension plans are quite different when compared to mutual funds. The difference between pension plans and other funds have been explained below:

• Tax Benefits: Pension funds are considered to be an asset class for the working-class population. Very few millionaires invest in pension plans. Also, if people can support themselves in old age via pension plans, the state does not have to bear their expenses. It is for this reason that governments all over the world give preferential treatment to pension funds. If the same amount of money is invested in mutual funds as well as tax funds, the corpus of the pension fund will be significantly higher because of lower taxes.

• Lock-in Period: The problem with pension funds is that the money gets locked in over a very long time period. In most cases, investors are not allowed to withdraw their money before their retirement. This is not the case with mutual funds where money can be withdrawn whenever required. The longer lock-in period allows compounding to increase the returns over a long period of time. However, it also takes away liquidity, which is very important to many investors.

• Reinvestment Risk: People with pension funds do not have to face reinvestment risks, and the associated transaction costs every time. On the other hand, people who invest in short term vehicles such as mutual funds face higher transaction costs. This also reduces their return.

• Regulation: The biggest difference between pension funds and mutual funds is the degree of regulation. Pension funds are not allowed to invest in any security, which is below investment grade. On the other hand, mutual funds may invest in any security which they feel will provide them with high returns. This high regulation is both a boon as well as a bane. It provides more security to investors but also reduces the expected rate of return.

It would, therefore, be fair to say that pension funds are a vital part of the financial system. A lot of securities are specially created so that they can be marketed to pension funds. This is because these funds provide stable long term source of income.