Pension Plans Explained: Defined Contribution vs Defined Benefit Plans

Updated : Sep 17, 2019 in Articles

Pension Plans Explained: Defined Contribution vs Defined Benefit Plans


Hi, welcome to this tutorial on personal
finance and financial planning. We’re going to be talking about pension plans.
That is, the difference between two different types of pension plans: the
‘defined contribution plan’ and the ‘defined benefit plan’. Alright so let’s
get cracking! Okay, this is what we’re going to cover in the tutorial. We’re gonna have
this introduction, then we’re going to talk about what pension plans are.
Following that we’ll talk about the key differences between defined contribution
and defined benefit plans. Next up we’ll be talking about the accounting for the
two types of plans. And finally we’ll be talking about the personal finance
implications for both types of plans. And then we’ll have a conclusion and a
wrap-up. Ok, since this is about financial planning, personal finance and financial
advice, I have to give you this disclaimer. The business AccoFina, and
myself the individual, are not giving personal advice in this video. It is
meant to provide factual information for educational purposes. We do not know your
personal circumstances and financial goals.
Neither AccoFina or myself hold an Australian Financial Services License (AFSL)
nor are we authorized representatives of an Australian Financial Services License (AFSL)
holder. That is we are not a licensed financial adviser. We are not giving
personal advice, nor general advice. We are only giving factual information. This
is general information only and should not be taken as constituting
professional advice. You should consider seeking independent legal, financial,
taxation or other advice to check how this information relates to your unique
circumstances, before taking (or not taking) any actions.
AccoFina and myself are not liable for any loss caused, whether due to
negligence or otherwise arising from the use, or reliance on, the information
provided directly, or indirectly, by this video. Okay so what are pension plans? In
general, they’re individual investment accounts to assist funding your
retirement. So their private, individual investment
accounts. They’re generally not funded by the state, they’re generally funded by employers
or individuals themselves. And the key idea is that: individuals in recent times
are being encouraged to better fund their own retirement, through individual
investment accounts. Now these can reduce the burden on the state, while also
improving the standard of living in retirement. So in the past you may have
the state, or the government, provide all pensions, and state pensions and
retirement income needs for retirees, but in recent decades there’s been a
movement towards individuals having their own retirement accounts, that hold
investment assets within them. Now these accounts can be funded by employers, or
individuals themselves. And often they receive favorable taxation treatment. So
you may be set up with one if you apply for a tax registration number, or a tax
file number. Or when you begin your working life, you’re set up with one of
these individual investment accounts. And they do receive favorable taxation
treatment. So that’s how the government still contributes to your retirement
even within these accounts. It (the government) incentivizes funding these accounts by
making the investments, ah, very tax effective. Okay these accounts have
restrictions, limits, or disincentives and penalties, on accessing the funds prior
to retirement. Pension plan systems are often dependent on the state or
national jurisdiction. So this video may be played anywhere in the world, so I
have to talk in generalizations. But you’ll find specific systems, structures
and rules are based on where you’re located. So for example, if you’re in the
U.S. you may be familiar with 401(k) accounts, and 401(k) accounts have
different rules, or specific rules, applying to them. Here in Australia we have
superannuation accounts, and these superannuation accounts are normally
within a superannuation fund, ah, or they are within a superannuation fund. And
they can be managed by fund managers or even ourselves, or our family
members, in an SMSF. And in ireland, you might have a PRSA, which is a
Personal Retirement Savings Account. Now they’re just three examples, and the
point is that they vary all over the world. Okay, but this is what the point of
this tutorial is about: now no matter where you’re located the
consensus view is that there are two distinct types, or categories, of pension
plans. These are the ‘defined contribution plan’ and the ‘defined benefit plan’. These
are the two types of plans that are normally occurring, wherever you are in
the world. And we’re going to be talking about the defined contribution plan, and
the defined benefit plan, for the rest of this tutorial. Okay so what are the key
differences between the two types of plans?
So there’s defined contribution plan first up. And this is where the
employer is only obligated to contribute a set amount each period.
There is no guarantee of future benefits for the employee, as the employer is only
committed to the contribution. For example, there’s the SG minimum 9.5% of earnings in Australia. The employee bears all the
investment risk. So, let’s take a step back. So if you’re working for a
particular employer who’s obligated to contribute to a pension plan, as part of
your salary, a defined contribution plan only obligates the employer to
contribute to your fund. Now once they’ve contributed, say 9.5%
of earnings in Australia, and they’ve paid that, perhaps in August of 2018, then
there is no obligation of the employer beyond that contribution. And this is
where the idea of no guarantee of future benefits that comes in. Once the
contribution is made, by the employer, it is completely up to the employee about
the performance of that contribution, and that investment. So if the employer pays
this every quarter, for 20 years (for example), and suddenly,
this is practically impossible, the markets all go to zero. And all of
our previous 20 years contributions go to zero, as well, then we have no claim on
the employer for our retirement income needs. The employee, us, bear all the
investment risk, after the contribution is made. And that’s why it’s called a
defined “contribution” plan. If you’re confused by any of those explanations, please leave
a comment, I’m happy to clarify things. It’s always easier to explain things in
your head, as opposed to into a microphone on the spot. So yeah, feel free
to comment if you need any clarification. Now here’s the second type of plan. As
opposed to a defined contribution plan, this is a defined ‘benefit’ plan, so it’s
not about contributions, it’s about defined benefits. Now in these types of plans the
employer is obligated to provide an income stream, post retirement. And the
employer bears the investment risk. See these plans? Where prior all they
had to do was put in a contribution. With these plans, the employer is promising a
certain level of income, once you retire. Now the income stream, or the the amount
of that income stream, once you retire can be dependent on a variety of factors.
So a defined benefit plan may have a formula that incorporates the length of
service, or your salary at retirement, and that could impact how much income you
receive once you retire. Now the rules, and the construction, of these plans are
all unique. So let’s go to where this important section is: about the employer
bearing the investment risk. So this time employers aren’t guaranteeing that
they’ll contribute to your fund, they’re guaranteeing you, that they will provide
you an income stream, post retirement. So they’re promising a particular income
stream, and therefore, it’s up to the employer to have the assets within the
fund, to meet these commitments. Now do you see the difference between the two plans? So
one, the employer just contributes and meets their obligations. The other one, the
employer must have a certain level of assets, to meet the obligation to have a particular income stream in your retirement. Again, if I explain this
poorly please comment and I can probably explain it with more thought, and
accuracy, in a comment. But, um, I hope you understand. Now with defined benefit
plans, these plans can cause huge liabilities for some companies, and
they’re being phased out & defined contribution plans are becoming the
standard. So if you look at it from employers point of view, they would much
rather, or it’s not much rather, but they would probably, for financial security,
rather make a contribution today, and have no obligations in the future. Under
a defined benefit plan, not only do they have to contribute to particular funds
today, but they have to manage those funds and make sure that they can meet
all the promised income streams, for all their particular employees, in perpetuity
or at least until all the retirement fund members, um, pass on. So these type of
liabilities can be very large for some companies, and is one of the reasons why
they’re being phased out, and defined contribution plans are becoming the norm.
Okay, so let’s talk about accounting for both. So the defined contribution plans
have much simpler accounting. And here we were talking about from: the
employers financial statement viewpoint. Now in the employers financial statement,
within the income statement, they’ll simply have pension expenses, and they’re
just the contributions that the employer made in the prior period. And on the
balance sheet there is no impact, whatsoever.
They don’t recognize anything on the balance sheet because there are no
assets or liabilities, related to their employees retirement funds. All they
had to do was contribute, and then their obligations are met. As for the
alternative, and the defined benefit plan, these (have) much more complex accounting,
and we won’t cover this in detail here. There’s even differences in accounting
between IFRS and US GAAP. In shorthand, on the income statement,
they’ll be pension expenses also for the defined benefit plans. And these would
involve new pensions earned by employees, benefits paid from past employees,
plus interest income and interest expense, from the plan assets. But he’s
the critical part: this is where the defined benefit plans impacts a balance
sheet, for employers. Now on one hand, the retirement fund will have the ‘plan
assets’. So these are, ideally, all the contributions that the employer has made
into the plan, for its employees, for its future obligations. And so on one side
you have the Plan assets. On the other side, you have the estimated present
value of all pension obligations. And then either: you’ll have a ‘net pension
asset’ or a ‘net pension liability’ on the balance sheet. So let’s work with an
example, here. Let’s say there is a company called, Biggles Ltd.
Biggles Ltd has 500 employees, and it has a defined benefit plan for all 500
employees. Now what Biggles Ltd has to do, with its financial statement, is
estimate the present value for all the pension obligations over the retirement
lives, of those 500 employees. So we’d have to calculate, “Okay, now depending on
each of those 500 employees, how much income do we have to pay for each of
them in their retirement? And then we bring that back to present value, and
then that’s our liability in this equation”. Now, hopefully, Biggles Ltd
has been planning for these pension liabilities, ah, the whole time, and they
would have put particular assets or investments into the Plan, at previous
periods. So, on the other side of the equation had the plan assets, and
compares them to the estimated present value of the pension obligation. Now
depending which of those sides is bigger, they’ll either be a net pension asset, if
the Plan assets are bigger. Or a net pension liability, if the present value
of the pension obligations is larger. And I hope that makes sense. All right so
we’ve done with the accounting side, but let’s look at the personal finance side.
So let’s say you’re involved in a defined contribution plan, which is a lot
of the younger employees nowadays. What you have to do is: You
to monitor the performance of your contributions. Now since the employer has
made the contribution that obligates them to do nothing more. The employee bears the
investment risk, so you have to monitor the performance of those contributions.
Now wherever those funds are invested, are they doing what you hoped they would
do? You’ve got to also monitor the allocation of the contribution(s), and a
total balance of the account funds. So where are these contributions being sent?
Many people when they’re young don’t even consider where their pension is
being allocated. But you should have some sort of portfolio management strategy
throughout your entire working life, to work out where your pension
contributions are being allocated; whether they’re being in defensive
assets, growth assets, balanced assets, or particular sectors and so forth. But the
ultimate responsibility is that, the individual must plan for the required
balance of these funds, for retirement. So you take on board the previous two tips,
about monitoring to the performance of contributions and monitoring their
allocation, and you need to adjust your own contributions to meet your target. Or
adjust your number of hours worked. So specifically, you’ve got to determine your
post retirement income needs. How much income do you want to generate in your
retirement, on your investments, that will fund your retirement? Now given that post
retirement income requirement, you have to estimate the balance needed, that
should hopefully generate that income. So if you need $100 a year in
your retirement, as income, which is unrealistically low, then you have to
work out, “Okay assuming my investments earn me 5% per year, and I need
$100 then I would need $2,000 in my retirement
account, for retirement. Given that $2,000 balance you would need
for retirement, then it’s up to you to plan to reach that balance throughout
your working life. So you have to adjust your contributions, you have to adjust
your hours worked, you have to monitor how your contributions are performing, and
it’s up to you, as you bear the investment risk, to reach that particular
required balance once you reach retirement. Okay as for
the personal finance implications for defined benefit plans. So we have
employers bearing the investment risk. But sadly, it’s no guarantee of plain
sailing. It should be up to you to monitor the financial strength of the
Plan That is, are there enough Plan assets to
meet your entire retirement? Now we’ve all heard horror stories about
retirement funds not being able to meet their pension needs, of their defined
benefit plans. So you have to monitor to make sure the financial strength of your
plan is adequate. For instance, is there an insurmountable net pension liability
that means that your retirement plans won’t be met with the required income
stream? And this can also mean monitoring the business funding the plan
assets. If you were working 40 years at Biggles Ltd and you retired then, and
expected to live another 35 years beyond that. Then you might have to
monitor how Biggles Ltd performs over those 35 years, because if Biggles
Ltd goes under, then you might find that your retirement fund no longer has
the contributions to build up the assets, to fund your retirement. Secondly you
have to monitor communications from the managing entity, and the fund manager.
So, stay in the loop of how the assets are performing, and being governed. It
shouldn’t just be a ‘set and forget’. So even if the contributions are being made
from the business, a market crash may put the plan under pressure. So under
these plans, the employer has promised a certain income stream but if there’s
simply not enough money in the fund, then something is going to break. So you
should monitor the communications, stay in the loop of how things are going, ah,
whether there’s any warnings, or whether the financial strength is good. And also
be careful of how they’re governed. And this final one’s quite important: But try and
learn how the rules of your defined benefit plan works. Now they can be very
complicated, and many people use a financial planner or financial advisor
to pick apart how they work, but try and find out what you’ll be
entitled to, um, under your plan, or any impact when you resign or change jobs.
And they’re just two examples, there’s a number of things you can learn about
learning the rules of how your defined benefit plan works, but um, it’ll really
help educate yourself & get empowered, if you know how you defined benefit plan
works. And each one of them is individual. Okay so let’s have this conclusion
and wrap up. What we’ve covered: What are pension plans? They are individual
retirement investment accounts. What are the key differences between the two
types of plans? And we talked about defined contribution plans and defined
benefit plans. We spoke about the accounting for both types of plans, and
that defined contribution plans have simple accounting. And defined benefit
plans have complex accounting, and importantly, impact the balance sheet of
the employer. And finally we talked about the personal finance implications, and
importantly: both types of plans involve retirement planning tasks to be
completed by the employee. You should care about it, you shouldn’t ‘set it and
forget it’, you’ll really have a better quality of life in retirement, if you take
control of your retirement pension plan. Okay that’s it, I hope it helped.
Best of success! If you enjoyed the video please subscribe to the Channel. Click on
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you can watch another on my tutorials, now. Or if neither of those interest you, um, I’d appreciate just a ‘Like’ of the video, that’d be great! Finally, feel free to
comment below if anything needs clarification, or if you just want to say
‘hello’. That’s really important, this isn’t a one-way conversation. Again, often what’s
in my head and what I put down in my notes, isn’t exactly what comes out when
I try to speak into the microphone. So if I’ve confused anything, or jumbled
anything, feel free to comment below and I will do my best to clarify anything, ah,
you ask.

1 Comment

  • First comment on the fresh Vid!
    Feel free to also comment & seek any clarifications. Also hope you can check out my Channel at https://www.youtube.com/accofina or visit http://accofina.com direct.

    Cheers, and best of success,
    Axel

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