Oran Hall | Weighing the two types of pension plans
ADVISORY COLUMN: PERSONAL FINANCIAL ADVISER
The defined contribution plan and the defined benefit plan are the two most popular types of pension plans, but there has been a steady shift from the latter to the former in private-sector pensions and, with it, a shift of investment risk from employers to employees.
The defined contribution plan, or money purchase plan, provides for an individual account for each participant. Contributions from the employer and employee are placed in the account of each member and invested.
The employee makes a required, or mandatory, or basic, contribution, which is a stated percentage of taxable salary. The employee may also make a voluntary, or optional, contribution, which is also a stated percentage of taxable salary up to which each employee may contribute.
At normal retirement age, or earlier termination, the member receives a benefit based on the amount contributed to the account, plus any income and gain thereon less expenses and losses. The benefit is often provided through the purchase of an annuity, which provides a regular income.
Before buying the annuity, the administrator solicits and receives quotations from institutions, such as life insurance companies, that sell annuities. An actuary may be hired to certify that the annuity can meet the needs of the employee, who must also agree to its terms.
Although the employee generally takes all the investment risk, some employers may top up the amount credited to the member's account if the investment returns are below a pre-determined level.
Should the yield exceed that level, the surplus is credited to the fund and may be used to enhance future pension benefits, or the employer may choose to reduce contributions to the plan. Although this approach protects the employee from the vagaries of the financial markets, he may be in a disadvantageous position when financial markets consistently yield good returns.
If the defined benefit plan is a contributory plan, the employee makes a required contribution and may also make an optional contribution, but the benefit is determined by a formula that can incorporate the employee's pay, years of employment, and age at retirement. In this type of plan, the sponsor or employer takes the investment risk.
An actuary calculates the contribution that the sponsor must make to ensure that the fund can meet future benefit payments, and the sponsor funds any deficit revealed by the actuarial valuation to ensure that pensioners get a full pension, effectively taking an open-ended risk. This is primarily why employers are increasingly becoming favourable to defined contribution plans.
How the benefits stack up
There are several similarities between both types of pension arrangements.
In each case, the benefit is usually paid as an annuity so that the pensioner does not bear the investment risk on his funds or outlive his retirement income. But large defined benefit schemes sometimes opt to pay benefits from the fund rather than buying an annuity from a third party.
The maximum pension payable to any individual is restricted to 75 per cent of pensionable salary regardless of the kind of scheme that he is a member of. If the investment returns on the money purchase scheme are sufficient to pay more than the statutory maximum benefit, future benefits may be enhanced. Benefits can be enhanced under the defined plan if the fund has an actuarial surplus. Alternatively, the employer may reduce contributions to either plan.
Both require the employer and employee to make contributions. Employees may also make voluntary contributions, which they may withdraw if they leave the plan. At retirement, the member may withdraw those contributions plus what they have earned or leave them in the fund to enhance his pension benefits.
The plans allow for the tax-free withdrawal of a lump sum at retirement with reduced, but taxable, benefits in subsequent years and offer more than one payment option.
Benefits may cease at the death of the pensioner or continue to the spouse thereafter, for example.
Finally, the sponsor generally retains investment discretion over the employee's compulsory contributions, but the employee may, once per year, determine how voluntary contributions are to be invested.
Because the employer takes the investment risk and is responsible for keeping the plan fully funded, the defined benefit plan is advantageous to the employee, who is assured of a steady income, but not to the employer.
The defined contribution plan is better for the employer, but not for the employee – if the employer gives no guarantees – because benefits are determined only by the investment value of the employee's account. Poor investment performance yields a small benefit to the pensioner.
Whichever plan is chosen, it is important that the employee knows his terms of employment and the rules of the pension scheme, taking care to ensure that benefits are calculated according to the rules of the scheme.
Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.