If you are a salaried individual you must have a pension plan offered by your employer. Understanding what type of pension plan your employer is offering is important to judge whether or not this plan is adequate and whether or not you need to separately save for retirement. Many people often suffer from a false sense of comfort with the employer offered pension plan and do not think that they need to save anything else but panic realising that their retirement benefits will not be enough just few years before retirement. At that point they neither have the time nor the risk bearing capacity to drastically change the situation. In this article we will talk about two primary classes of pension plans, their benefits and more importantly their limitations in retirement planning.
DEFINED BENEFIT (DB) PLANS
As the name suggests, this kind of pension plans assures benefits known beforehand. The pension payments are calculated based on years of service, salary history etc.
For the employee, the biggest benefit of a defined benefit plan is certainly associated with the pension payments. So, the risk associated with the pension plan rests with the employer. If the pension plan fails to generate enough returns required to make the projected pension payments, the employer needs to pay for the shortfall.
This makes the DB plans undesirable for the employers. Requirement of assuring returns and lower acceptable uncertainty means that the portfolio needs to be dominated by fixed income instruments and investment in equity has to be limited. In a decreasing interest rate environment this increases the shortfall of these pension plans and puts financial stress on the employers to maintain such funds. This may make whole plan unviable.
Due to above mentioned issues, only a limited number of employers offer DB plans – Govenrment Banks and Central Civil Services are such examples.
DEFINED CONTRIBUTION (DC) PLANS
This is where the defined contribution plans come. DC plans do not guarantee any assured return. Instead, it defines the contribution made by the employees and the employers. The employees have the freedom to choose the risk they want to take for their retirement plan. So, if one wants, she can choose conservative plans with lower risk or a growth plans with higher risk.
So, both the choice of investment selection as well as the investment risk is diverted to the employees. Most pension schemes nowadays are DC plans. Plans offered by the National Pension System (NPS) are also defined contribution plans.
IS YOUR PENSION PLAN ADEQUATE?
As we can see that both types of pension plans have some benefits and some limitations.
The issue with a defined benefit plan is that it is designed to take lower risk. This also means that while it provides security of the pensioner, the pensioner may miss to take advantage of high risk tolerance capacity, which comes with a secure government job and assured income.
It is highly recommended for these employees to create separate aspirational portfolios with growth investments – a higher proportion in equities and some alternative investments.
The issue with a defined contribution plan is completely different. As the burden of choice rests with the employee who in most cases do not have the skills of investment selection, may end up choosing investments completely different from what is suitable for their risk-profile and future goals. It is highly recommended that the people covered under a DC plan hire an investment professional to help them make the decisions, and if needed, create a complementary portfolio.