Defined Contribution Pension Plans

Defined Contribution Pension PlansDefined Contribution Pension Plans – In a defined contribution (DC) pension plan, workers accrue funds in individual accounts administered by the plan sponsor. The contributions of employees are typically deducted directly from their pay and frequently some portion of these contributions is matched by the employer. Since contributions to DC plans are generally a fixed percentage of earnings, DC assets build at a fairly steady rate over time (abstracting from the time-pattern of investment returns) – avoiding the backloading of accrued benefits that is a hallmark of DB plans1.

So in contrast to a defined benefit (DB) plan, it is the contributions rather than the benefit that is fixed in a DC pension plan; the retirement income that will be provided is unknown in advance. The pension benefit accumulated during the employee’s working career will depend on the contributions made while working and the investment returns earned on the plan balances. Defined Contribution Pension Plans

Similar to DB pension plans, there is considerable variation in DC plan design, legislation, regulation, and taxation; these differences influence the risks that plan members assume. Australian DC plans are somewhat unique. Participation is mandatory for all workers and their employers and minimum contributions are fixed by legislation. Defined Contribution Pension Plans

The most common type of DC plan in Canada and the U.K. is a traditional money purchase plan (MPP) organized as a trust2. In the U.S. MPPs are less popular than the 401(k) plan which, according to Borzi (2005) accounts for 75 per cent of DC plan members3. Defined Contribution Pension Plans

Nonetheless these plans have many features in common. Within specified limits, plan contributions and investment income are not subject to personal income tax although withdrawals are taxed4. The plans are also governed by pension legislation and regulation.

The main difference between a MPP and 401(k) plan is that the latter has features of both a traditional occupational pension plan and an individual retirement savings plan5. Early withdrawals from a 401(k) are permitted but are taxable and subject to certain conditions and penalties (prior to age 59 ½). Also, lump sum distributions are permitted at retirement and when an employee changes jobs.

In the U.K., Australia and Canada pension balances are locked-in until retirement age. Early withdrawals are not permitted and the purchase of an annuity is compulsory at age 69 in Canada and age 75 in the U.K.. In Canada, investment in a ‘locked-in’ retirement savings account where annual withdrawal limits are pre-specified is also permitted6. Employees in Australian DC plans typically have the choice of purchasing an annuity or taking the entire balance as a lump sum withdrawal (as early as age 55); early withdrawals are only permitted in exceptional circumstances. Defined Contribution Pension Plans

Under pension legislation, DC plan assets belong to the worker, meaning that previous contributions are portable across employers or through employment spells. In a DC plan this generally means that the DC plan assets are controlled by the worker. A worker may be able to leave the plan assets under the administration of a previous employer, transfer the assets to a new employer’s plan or transfer the assets to an individual retirement savings account. Defined Contribution Pension Plans

Similar to DB plans, DC plan benefits must be vested. If the plan is terminated prior to the vesting date, only employee contributions and interest are returned. By definition a DC pension plan is always fully funded and the employer typically has no financial obligation other than to make periodic payments into the plan, and, relative to a DB plan, the accounting treatment is quite simple ; payments to a DC plan are treated as any other corporate expense (Yermo, 2003). Defined Contribution Pension Plans

Thus, the constellation of risks facing workers covered by a DC plan is quite different than in a DB plan (See Table 2) : in a DC plan, workers bear investment and longevity risks, but do not face accrual risk7. Defined Contribution Pension Plans

Given that there is typically no mechanism for pooling investment risk in DC plans, the employee is also exposed to market timing risk at the point of retirement; this applies not only to the amount of cash balances available at retirement but also to the amount of annuity that can be purchased with this sum. A market downturn at the time of retirement could substantially erode the cash balance in a DC plan. Defined Contribution Pension Plans

For example, DC plan members who retired during the severe bear market in global equities from 2000-2002 are likely to have retired with a much smaller plan balance than individuals who retired during the stock market boom of the late 1990s. Defined Contribution Pension Plans

Likewise the level of interest rates at the time of retirement influences the amount of the retirement benefit if the employee is required (under pension legislation) or voluntarily decides to purchase an annuity. Defined Contribution Pension Plans

Defined Contribution Pension Plans

In a DC plan the employee assumes salary replacement risk as well. Employees must not only calculate the amount of savings needed to retire but must also make a series of complex investment decisions to achieve their retirement goals.

In many DC plans employees have considerable flexibility over participation, contribution amounts, portfolio allocations, and, in some countries, the timing of withdrawals; however, it would appear that a considerable fraction of workers have been dismayed by the wide array of options and decisions DC plans usually entail.

In other cases, DC plan members may bear investment risk without having control over the asset mix, or, alternatively are provided with a limited choice of investment options that may make it difficult to design an optimum portfolio reflecting their unique investment objectives and constraints.Ultimately, plan regulation and design influences the extent to which DC plan members are able to manage financial risk. Defined Contribution Pension Plans

Employers offering DC plans escape financial and longevity risks associated with DB payments, but then are denied access to the opaque accounting of pension assets and liabilities in DB plans common in many countries, including the U.S., Canada, and until recently the U.K.. Pension accounting seems to have, at times, allowed some firms to obscure the costs of their pension plans and even the actual volatility and level of net income8.

One risk that the employer may be forced to retain is the potential fiduciary/legal risk facing sponsors of DC pension plans. If employees retire from DC pension plans without sufficient retirement income this may be grounds for future lawsuits9. Defined Contribution Pension Plans

In principle investment returns should generate sufficient income for the average DC plan holder to retire with a comfortable income, provided contributions are made at a steady rate over the plan holder’s career.

A recent research paper by Andrew Samwick and Jonathan Skinner (2003) used simulations from a life cycle model calibrated to include realistic experiences for earnings, investment returns, and other key variables to compare whether typical DB plans or DC plans might leave workers better prepared for retirement10.

Their study focused on the U.S. pension sector, using data from the Pension Provider Survey (PPS) that was part of the Survey of Consumer Finances in 1983 and 1989 to gather information about key characteristics of DB and DC plans in place at that time. What they found was that by 1995 the typical DC plan (one that fell into the 401(k) classification) would be expected to yield about the same retirement income for the median worker and higher income for the average retiree compared with the typical DB plan that was offered in the mid-1980s.

The intuition behind their result is that investment returns, to a large extent, are uncorrelated over time, so that over the worker’s career periods of low returns tend to be offset by periods of high returns and overall “market” risk is not such a big problem for many workers. By contrast, DB plans tended to tie retirement benefits strongly to earnings in the final years of work and, as discussed above, disproportionately to tenure at the firm, so workers were exposed to a significant degree of “accrual” risk.

Across a typical range of risk aversion parameters, Samwick and Skinner found the costs of accrual risk tended to outweigh the costs from market risk. An important caveat to their main result is that failure to participate in an employer’s DC plan would, of course, cut significantly into expected retirement income from that source. Defined Contribution Pension Plans

Defined Contribution Pension Plans

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