Pros and Cons of a Fixed Benefit Pension Plan
Today, the defined benefit pension plan is viewed as being a relic of the yesteryears. Most of the plans offered now are fixed contribution pension plans. However, a lot of retirees still have a fixed benefit pension plan. Also, it is important to understand how defined benefit pension plans work just for academic purposes.
In the previous article, we already studied how defined benefit plans work. In this article, we will continue to explain the pros and cons of these plans.
Pros of Fixed Benefit Pension Plans
Defined benefit pension plans dominated the pension markets for many decades till the 1990s. Such dominance was possible because the company was able to provide several benefits to employees as well as employers. Some of these benefits have been listed below:
- No Investment Risk: It is important to understand that employees are generally risk-averse. They are not comfortable having their retirement corpus determined by a financial market. Even if the financial market provides a significantly higher return, in the long run, employees will prefer the safety that a fixed sum of money offers.
Defined benefit plans have virtually zero risk. This is because these plans are also insured to a certain extent. Hence, even if an employer or the fund goes bankrupt, the retirement savings of employees are secured. This security made defined benefit plans the darling of employees for a very long period of time.
- Easier to Plan Retirement Expenses: There is very little fluctuation or variance when it comes to defined benefit pension plans. Employees are aware of what their post-retirement earnings will be at a very early stage. This allows them to plan their retirement expenses keeping in mind the income that they are likely to generate. The elimination of uncertainty makes planning easier for employees.
- No Decision Making: Defined benefit plans require very little decision-making from the employees. The amount of money to be contributed as well as the asset classes where it needs to be allocated are all controlled by the employer. This may seem like a con. However, many employees view this as being an advantage of defined benefit plans.
Many employees do not have enough knowledge of the financial markets to make informed decisions. Hence, if they are given such choices, it confuses them and leads to unnecessary mental turmoil.
- Staff Retention: From an employer’s point of view also defined benefit plans were considered to be very useful. This is because the advantages of these plans increase after a few years in the same company. As a result, employees are encouraged to work for a longer duration at the same company. Hence, even if these plans seem to be expensive since the employer has to bear the difference between the pay-out and market value of the investments, they still save money for the employers who do not have to pay a higher wage bill.
Cons of Fixed Benefit Pension Plans
The fixed benefit plans also had some very important disadvantages which ultimately led to their ouster as the preferred pension plan type. Some of these disadvantages have been listed below:
- Uncertainty for Employers: The biggest disadvantage is that there is a lot of financial uncertainty for the employers. Their liability does not end once they contribute a certain sum of money towards the employee’s pension. Instead, they are liable to ensure that a certain dollar value reaches the employee after their retirement. If there is a shortfall in this dollar value due to poor market performance, then the employer has to pay from their own funds to make good the loss. This often leads to contingent liabilities on the employer’s balance sheet which drags down the valuation of the corporation.
- One Size Fits All Approach: One of the biggest disadvantages of the defined benefit plan is the fact that employees do not have any say in how their money is invested.
Since companies decide the asset allocation percentage, the investment is generally done very conservatively. The end result is that the annuity rate offered to employees is much lower than the one which would be offered to them on the open market.
- Lump-Sum Payments Not Allowed: Another major disadvantage of defined benefit plans is that they do not provide employees with the option to withdraw their savings in the form of a lump sum.
Instead, fixed payments are made on a monthly basis. Hence, employees do not have the flexibility to bear lumpsum costs related to their medical expenses, asset purchases, or other such expenses.
- Restricts Mobility: A defined benefit pension plan restricts the amount of job mobility that a worker has. If they join a new company, they have to forego a lot of pension benefits offered by their old companies. As a result, a lot of employees end up working for the same employer at below-market wages for long periods of time. Many workers have realized that their life savings have been negatively affected because of the defined benefit pension plan.
To sum it up, defined benefit pension plans had their pros and cons. However, employers are the decision-makers when it comes to the type of pension plan. This type of plan exposed them to a lot of uncertainty and possible financial loss. Hence, over the years, employers have steered away from the role of being a guarantor of retirement benefits toward being a trustee of these savings.
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