FIN200 Coorporate Financial Management & Termination Insurance

A.What are the important factors that should be considered by tertiary sector employees when they are deciding whether to place their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan? What issues relating to the concept of the time value of money may be important in this decision-making process?

B.“If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin.” Explain why this is not the case.

Answer:

A)Tertiary sector employees should consider all the factors which are mentioned below to decide which superannuation fund (Defined benefit plan or Investment choice plan) should be selected.

Defined Benefit Plan and Investment Choice Plan are the two most important form of superannuation contribution plan.

Defined benefit plan is a plan where benefits are paid to employees at the time of their retirement. Factors considered under Defined Benefit Plan are – Average salary of the employee, length of employment in the company and age of the employee. Under defined benefit plan employer bear the risk for return on investment and provide certain amount of retirement benefit to its employees.

Investment: choice plan is a simple retirement plan. Under Investment choice plan both employee and employer contributes into the employee’s retirement investment benefit account. Contribution made by employer under this plan is predetermined fraction of salary of employee. There is no compulsion that predetermined fraction of salary remain constant over the period of time. Under Investment choice plan there is no guarantee on return on investment. Determinants of Investment choice plan is contribution made by employer and employee at the end of each year.

Factors that should be considered by tertiary sector employee to decide between Defined benefit plan and Investment Choice Plan are following:

Investment risk: Investment choice plan has investment risk as compared to Defined benefit plan. Defined benefit plan provides guaranteed amount of money whereas in Investment choice plan there is no guarantee of amount of money (Dulebohn JH, 2000). Conservative employee prefers to opt Defined Benefit Plan.

Insurance: Defined Benefit Plan provides insurance cover to employees whereas Investment choice plan does not provide insurance cover to employees. Insurance is one of the factors that should be considered by employees of tertiary sector.

Guaranteed income stream: Under Defined benefit plan there is guarantee of income stream subject to indexation of CPI, for remaining period of his/her life. But this facility is not available under Investment choice plan.

If the employee of tertiary sector chose defined benefit plan then superannuation contributions are pooled together and invested in selected asset which is determined by the company and employee will get fixed amount of money. Under this option asset portfolio is not relevant and employee will get fixed retirement payout. But if employee of tertiary sector chose Investment choice Plan then superannuation contribution are pooled together and invested in selected asset which is determined by employee itself. In this case employee will bear the investment risk and it will affect retirement payout.

Under Investment choice plan, employee can invest these funds which are described as follows: Shares fund, secure fund, Stable fund, Trustee’s selection fund.

Employees who opt for Investment choice plan, there final retirement payout depends upon return which is generated by their investment portfolio.

Investment result: Under Defined benefit plan, investment result will not affect your benefit whereas under investment choice plan, investment result will affect your benefit.

Determinants of Defined benefit plan and investment choice plan: Factors affecting defined benefit plan are: age of employee, serving period of employee, salary of employee. Factors affecting Investment choice plan are: contribution made by employee and employer, return on investment, expenses incurred.

Hence service period of employee, salary growth of employee, age of the employee , vesting period, inflation, these all are the factors which plays an important role in deciding whether to choose Defined benefit plan or Investment choice plan by employee of tertiary sector.

Termination and portability: As per the portability with respect to consideration then Investment choice plan is more portable than Defined Benefit Plan. Under defined benefit plan if employee leaves his/her job due to uncontrollable reason then in this case employee will not able to enjoy the benefit of defined benefit. Hence Investment choice plan is more considerable if portability is considered. Under Defined benefit plan, penalty will be imposed on employee on early termination, hence Investment choice plan have advantages over Defined benefit plan.

Incentives: In Investment choice plan, pension benefit of employee depends upon wage trajectory over the working period of employee whereas in Defined benefit plan, pension benefit of employee depends upon the final average salary of the employee. Because of this reason, Defined benefit plan is more beneficial than Investment choice plan on the aspect of incentive. In Defined benefit plan, incentive is more as compared to Investment choice plan because of high average salary of the employee at the end of his/her career (Vincent, 1983).

Iformational economies in plan design and implementation: Planning of income which is derived at the retirement is very complex (McDermed, 1990). Most of the employees consider that employer should provide adequate retirement benefit for them. An income goal of retirement of employee is defined as % of replacement rate of salary. Defined benefit plan is easy to understand as it is very easy to interpret Defined benefit Plan. But under Investment choice Plan, rate of contribution is adjusted time to time to achieve the desired rate of replacement.

Risk of wage-path: It plays an important to decide which plan will be selected by employee of tertiary sector. In Defined benefit plan, pension benefit depends upon the average final salary of the employee whereas in Investment choice plan, pension benefits upon the contribution made by the employer and employee during each year. If wage path of employee is not predictable than Investment choice plan is more beneficial because wages of employee is not known, hence employee has no idea about its future average salary. Defined benefit plan after taking the effect of inflation will provide the same result. Feature of time averaging is getting through Investment choice plan. Under investment choice plan, pension benefit depends upon contribution rather than final wages of employee.

Risk of interest rate: Under investment choice plan, there is no certainty of retirement income whereas in Defined benefit plan there is guarantee of interest rate through life annuities. In fact without indexation of retirement benefit, there is certainty of nominal interest rate rather than real interest rate. But the value of nominal interest rate among employees is questionable when inflation in future can be predicted by them. Investment choice plan can also provide nominal interest rate with certainty when deferred annuity plan is purchased as Defined benefit plan.

Inflation: During the period of inflation Investment choice plan is more beneficial than Defined benefit plan because employee can invest in inflation hedged portfolio rather than nominal annuities. (Bulow ,1982)

Conclusion:

Nowadays employees are shifting from defined benefit plan to investment choice plan because of expense and long term obligation required under defined benefit plan. Defined benefit plan is more attractive in early period of employment whereas Investment choice plan is more attractive during later period of employment.

Importance of time value of money in decision making process whether to choose defined benefit plan or Investment choice plan by employee of tertiary sector:

Basic Assumptions:

It is assumed that contributions are made at the end of the every year.
Growth in salary remains constant from year to year.

Under Investment choice plan, retirement benefit increases from one year to next year as follows:

I (n+1) = S (n) *C + E (n) * [1+I (n)]

Retirement benefit under investment choice plan increases because of these two reasons:

Contribution is made to the fund
Income of the investment on the balance 1 year earlier.

Under defined benefit plan, benefit increases from year to next year as follows:

D(n) = S(n) * M* Y(n)

D(n+1)= S(n+1) * M * Y (n+1)

= S(n) * M* {Y(n) +G(n) + Y(n) *G(n) +1}

= S(n) * M* Y(n) * (1+G[n] + S(n) * M

= D[n] * (1+G[n]) +S (n) *M

Retirement benefit under Defined benefit plan increases because of these two reasons:

The salary of employee has been increased by G(n)
The retirement benefit is multiplied by salary of one additional year.

Symbols: Y(n) denotes year of service

E(n) denotes investment earnings

G(n) denotes growth in salary

C denotes contribution rate

M denotes multiple benefits

I(n+1) denotes benefits from investment choice plan after one year

D(n+1) denotes benefits from defined benefit plan after one year

Investment choice plan is preferred if

For example:

Harry is 22 years old and working in a company with the base salary of 25000 and recently he completed his 1 year of service.

Under Defined benefit plan retirement benefit will be 2% of Harry’s final salary * no. of years he worked for the company.

Let assume that Harry works for 45 years in a company and he will receive 2% annual growth rate for every year he worked for the company.

After one of service in the company, under defined benefit plan harry will receive:

1219 which is calculated as follows

After retirement, Harry will receive 1219 every year for 30 years (30 years is assumes as his life expectancy rate)

Now we will calculate Present value obligation. To calculate this, Harry’s retirement benefit needs to be converted into lump sum amount (use 4% yield for 30 year treasury bond) .

By doing this, we will get the present value of harry’s defined benefit plan (with life expectancy of 30 years) i.e. 21079.

21079 specify that company have to pay this amount to harry to satisfy his defined retirement benefit plan when he will retire

Therefore Time value of money plays an important in determining superannuation contribution (Defined benefit plan or Investment choice plan) for the employees of tertiary sector of the company.

B)The efficient markets hypothesis does not imply that portfolio selection should be done with a pin due to the following reasons:

(1) The manager must make sure that there should be well diversification in the portfolio. It should also be considered that if stocks are in large number then it does not provide guarantee of diversification in portfolio because they could be belongs to same industry. Well diversification is very important in the portfolio; if portfolio is not well diversified then it will increase the risk. Stock should be belongs to different industry if they belongs to same industry then this will not lead to diversification in the portfolio. The mixture of securities in the portfolio varies according to the age, goals, and tax bracket (applicable to investor) and risk aversion of the investor

(2) Second, pension fund manager assured that the risk of the diversified portfolio is appropriate for employees. In the case of pension fund, pension fund manager should select safe investments that means choose stock or combined portfolios which have lower beta(Sherry, 2002). Value of beta should be low to minimize the risk or to reduce the level of risk. In retirement benefit plan there should security of return, that’s why there should be low level of beta. Amount should be invested in those stocks whose beta is less as compared to others. If beta is more, then risk on return on investment will be high and if beta is low then in that case risk on return on investment will be low. Hence risk of the diversified portfolio should be appropriate.

(3) Third, pension fund manager might wants to tailor the portfolio to take the benefit of tax (benefit related to tax) for pension funds. It helps the pension fund manager to increase the expected return of portfolio without increasing the level of risk. From tailoring the portfolio, pension fund manager can increase the expected return of portfolio (without changing the level of risk). Pension fund manager should take the benefit of special tax laws in case of pension fund.

These are the reasons because of which efficient markets hypothesis does not imply that portfolio selection should be done with a pin.

References

Gallery N (2002),” Informed superannuation choice: constraints and policy resolution” [Accessed 18 may, 2017]

McDermed (1990), “The Choice of Pension Plans in a Changing Regulatory Environment”. AE Press. Washington, D. C.

Vincent (1983),” Termination insurance for single-employer pension Plans” [Accessed 17^th May 2017]

(1977),” Immunization, duration and the term structure of interest rates”[Accessed 18^thMay 2017]

Gorge (1977),” Coping with the risk of interest rate fluctuations”, Journal of Business [Accessed 17^th May 2017]

Zvi (1982), “An innovation for stable real retirement income”.PI Press, London W.C.

Bulow (1982)” What are corporate pension liabilities?” Quarterly Journal of Economics [Accessed 18^th May 2017]

Ellwood (1985)” Pensions and the labor market: A starting point, University Of Chicago Press, Chicago

Cohn (1993),” Inflation and corporate financial Management”, PI Press. London

Anonymous, “Comparing investment plan and defined benefit plan”, https://www.myfrs.com/pdf/forms/ee_brief_dbdc_comp.pdf [Accessed 17th May 2017]

Alan (1988), “Defined benefit versus defined contribution”, https://www.nber.org/chapters/c6047.pdf [Accessed 17th May 2017]

Kerry Brown,” Employees’ Choice of Superannuation Plan”, https://eprints.qut.edu.au/4810/1/4810_1.pdf [Accessed 18th May 2017]

Anonymous (1999),”Superannuation Scheme”, UniSuper Management Pty Ltd, Australian Universities.

Anonymous (1988), “Senate Select Committee on Superannuation Choice of Fund”, 28^th Report, Canberra: Parliament of the Commonwealth of Australia.

Sherry (2002),”Choice of Superannuation Funds”. Canberra: Parliament of the Commonwealth of Australia.

Dulebohn JH (2000),” Selection among employer-sponsored pension plans”, AEI Press, London.

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