Superannuation Retirement Schemes For Time Value Of Money

Factors Affecting Superannuation Contributions

Discuss about the Superannuation Retirement Schemes for Time Value of Money.

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This report is based on a company’s case study named UniSuper Ltd. This company provides various superannuation retirement schemes for its employees which are distinguished in nature. Two of the most prominent schemes are Defined Benefit Plan (DB) and Investment Choice Plan (IC), also known as Defined Contribution Plan. Such schemes have gained importance in previous years because these investments are aimed at securing one’s future and non- working part of their life. The report is based on identifying factors that affect an employee’s decision to choose a particular scheme and the impact of these factors in selecting the amount of contribution to such schemes. For this context, Defined Benefit Plan and Investment Choice Plan are discussed in detail. The most important factor to be considered while choosing any one of them is the time value of money.

It will also be discussed that how will time value of money influence decision- making process of employees. The potential returns or retirement savings that are derived from these schemes are of utmost importance. Some researchers have also argued that the time value of money concept render Defined Benefit Plan ineffective when compared to investment returns from other schemes.

This will be discussed further. The underlying case study of the company, UniSuper Ltd. suggests some retirement plans for its employees which will be discussed. The report also consists of ascertaining the most preferable retirement plan for an employee (Jefferson & Preston, 2005).

Generally, employees save some part of their salary to be used for their retirement. Superannuation is one of the ways for employees by which they can fulfil this purpose. In such schemes, employer contributes some percentage of employee’s salary to the fund and the rest is deducted from employee’s gross salary. Sometimes, there is a contribution from government authorities as well. How much an employer, employee or third party (government) will contribute depends on various factors. Few of which are discussed below. These factors also depict which scheme an employee is likely to choose.

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  • Regulations by government

In Australia and even in other countries, there are regulations by government which compel employers to contribute a minimal amount to employees’ superannuation funds. Research studies in Australia show that people working there tend to have a greater life expectancy than before. In addition, they are inclined to retire at an earlier age. This implies that there is a critical need for them to manage super funds for their retirement. Currently, the rate is 9% of the employee’s salary which is to be contributed by the employer compulsorily. However, few small- scaled employers are exempted from this regulation (Worthington, 2008).

  • Age of employees

Defined Benefit Plan (DB)

It has been studied that older people tend to contribute more to such funds as they have relatively higher saving instinct. Reason may be that young people are more reluctant to save, instead they believe in spending. However, elderly people have a more mature thought process which asks them to save for comfortable and luxurious future (Hurnard, 2005).

  • Income groups

Another factor affecting superannuation contributions is the income group in which employees fall. An employee from low income group is likely to contribute a little amount to super funds because he has other obligations to fulfil. And, with his low income, he can satisfy only the most urgent ones. On the other hand, a high- income group is likely to contribute a greater share to super funds (Drew & Stanford, 2003).

If the employee’s risk appetite is high, he/ she will invest Investment Choice Plan and vice versa (Brown et al., 2004).

  • Time value of money considerations

When time value of money is considered, Defined benefit Plan is likely to lose value in future, which is discussed below (St John, 2009).

These plans are sometimes called as qualified pension plans. It is one of the most common retirement plans. A major part of such funds is contributed by the employer.  In such a scheme, amount to be contributed by employer and final amount credit to the employee is calculated using some mathematical formula.  The formula goes as follows.

Retirement benefit = benefit from salary * term of employment * lump- sum factor * average service fraction.

The name of this scheme includes the word ‘defined’ because the way to calculate employer’s contribution is known well in advance. There are some regulations even for the time and amount of withdrawal by employee. These schemes also provide a tax benefit to the employee (Scott, 1994).

Investment choice plan is another scheme for employees to save for their future and retirement. Like any other superannuation scheme, there is an employer- employee contribution in this scheme as well. However, computations are a bit different. The funds are invested in various financial assets. Employees have a facility to choose type of financial asset in which their fund can be invested based on their risk appetite and return required. The retirement benefits of employees comprise of the gains of their funds which are invested in various financial instruments after deducting any administration or management overheads. The company under study provides four options for employees. First are secure funds in which funds are invested in fixed income bonds of Australia. These are least risky, but provide low returns. Secondly, they have stable funds mostly invested in fixed income securities but also spare some part for equity shares.  Trustees’ selection fund is another type in which investment in both risky and secure assets is balanced. The highest return giving, but the most risky fund is share fund with a large exposure to equity market (Poterba et al., 2007).

Investment Choice Plan (IC)

Time value of money illustrates the financial impact on money value that gradually deteriorates due to inflation and other economic factors like interest rates. It is also known as discounted value of money. The amount of money that one is having today will not have the same value after five years. It is illustrated by an example. I have AUD 210 and I have to buy 15 CDs worth AUD 14 each. After five years, the price of a CD rises to AUD 15 from AUD 14. Now I will be able to buy only 14 CDs with the same amount of AUD 210. This means that value of AUD 210 has depreciated with time. This is the time value of money (Halperin, 1996).

The time value of money concept significantly affects the decision- making process of employees when they choose which policy or scheme would be better for their retirement. If an employee chooses Defined Benefit Plan, then he/ she might forego some value of their money in future. We have already discussed that due to time value of money concept, the value of money degrades in future to a certain amount due to inflation and interest rate forgone, had they invested money in some banking product. So, the amount that employer contributes to the super fund of Defined Benefit plan is devalued in future and employee ends up with lesser amount. Besides that, in Investment Choice Plan, the employee will receive money adjusted to time value because returns from various investments will be adjusted according to inflation and interest rate movements of the market, i.e. real returns will be there. Hence, this factor is keenly considered before making a decision on which scheme to choose.

So, time value of money affects the choice of employees regarding retirement schemes. This study shows that Investment Choice Plan is better to invest. But not all employees invest in this scheme. The reason is risk factor and certainty factor. IC plan inhibits a greater risk and is not suitable for a risk-averse person. Secondly, returns in IC plan are not stable enough. Sometimes you get a high amount and at other times, a lesser amount is earned. This uncertainty makes employees reluctant to invest in IC Plan (Vidler, 2004).

Potential investment returns, in context of Investment Choice Plan are the returns that can be earned from the pool of investments a fund has undertaken. It depends on the risk appetite of an individual and type of assets he/ she has invested in. Whereas in context of defined benefit Plan, retirement savings is the appropriate term since it simply saves a part of salary to be used in future.

Time value of money- The concept

However, studies show that DB plan gives more consistent returns and even higher returns than IC plans. Reason being IC plans is subjected to market risk. This affects the overall average return earned by them (Munnell et al., 2015).

Before we check the impact on any particular scheme, present- future value considerations should be understood in general. In context of our case study, if an employer promises today a retirement benefit worth AUD 200 to be paid for next 15 years of service, then we can say that future value of payment is AUD 200*15, which is AUD 3000. But in time value of money concept, the future value can be calculated as

Future value * (1-(1/ 1+interest rate) ^ no. of years)/ interest rate. The present value in this case is AUD 2074, instead of 3000. This shows that employee will get less in real terms, if he chose to invest in Defined Benefit Plan. Hence, we can say that a person investing in such a scheme will forego potential investment returns that could be earned while investing in some other scheme (Hariga, 1995).

Besides two major retirement schemes discussed above- DB plan and IC plan, the company UniSuper Ltd. provides a wide range of retirement and pension plans. We have already discussed the range of IC plans in which an employee can invest his fund according to the amount of risk exposure he wants (Disney & Johnson, 2001).

Apart from that, there are many pension plans well. Few of which are discussed below.

  • Index- linked pension plans: In these plans, returns are related to some inflation index to provide real returns to employees. And, if employee dies, the fund is transferred to his dependants.
  • Single life index- linked plans: It is same as above, but it is for employee only. The amount is not transferred to dependants (Bodie, 1989).
  • Allocated pension funds: These schemes allow an employee to withdraw the amount before retirement, if they have some urgent need.
  • Roll- over pension funds: These funds give the facility to change the type of fund they have invested in, if they want so in future (Choi et al., 2002).

The attractiveness of a retirement plan depends on an individual’s risk appetite. Besides that, time value of money is another important concept to be considered to ascertain the relative attractiveness of the plans.

Based on time value of money, the most attractive plan is IC plan. It is substantiated by an example. An employer contributes AUD 100 for next 5 years to the employee’s super fund of Defined Benefit Plan. The interest rate foregone is say 5%. So, in future, employee will get AUD 500. But according to time value of money, actual future value of the fund should be as follows.

An annuity of equal payments of AUD 100 for 5 years with interest rate of 5% will have a future value calculated as future value= amount * (((1+interest rate) ^ no. of years) – 1)/ interest rate. This gives future value of AUD 552.56. But employee will receive only AUD 500.

However, this opportunity cost will not be incurred in IC plan because they provide real returns (adjusted for inflation) based on market performance.

Based on risk appetite, following plans will be attractive for different class of people.

Employee group

Type of retirement plan or scheme

Highly risk- averse

Secure funds

Risk- averse

Stable funds

Risk- neutral

Trustee’s selection funds

Risk- loving

Share funds

Real returns required having dependants

Indexed- pension funds

No dependants but require real returns

Single- life indexed pension funds

Require money before retirement

Allocated pension funds

Want to change the type of scheme later

Roll- over pension funds

(Blake, 2000)

References

Blake, D., 2000. Does it matter what type of pension scheme you have? The Economic Journal, 110(461), pp.46-81.

Blake, D., Cairns, A.J. & Dowd, K., 2006. Living with mortality: Longevity bonds and other mortality-linked securities. British Actuarial Journal, 12(1), pp.153-97.

Bodie, Z., 1989. Pensions as retirement income insurance.

Brown, K., Gallery, G., Gallery, N. & Guest, R., 2004. Employees’ choice of superannuation plan: Effects of risk transfer costs.T. The Journal of Industrial Relations, 46(1), pp.1-20.

Choi, J.J., Laibson, D., Madrian, B.C. & Metrick, A., 2002. Defined contribution pensions: Plan rules, participant choices, and the path of least resistance. Tax Policy and the Economy, pp.67-114.

Disney, R. & Johnson, P., 2001. Pension systems and retirement incomes across OECD countries. Edward Elgar Publishing.

Drew, M.E. & Stanford, J.D., 2003. 322 A review Of Australia’s compulsory superannuation scheme after a decade.

Halperin, D.I., 1996. Interest in Disguise: Taxing the” Time Value of Money. The Yale Law Journal, 95(3), pp.506-52.

Hariga, M.A., 1995. Effects of inflation and time-value of money on an inventory model with time-dependent demand rate and shortages. European Journal of Operational Research, 81(3), pp.512-20.

Hurnard, R., 2005. The effect of New Zealand Superannuation eligibility age on the labour force participation of older people. New Zealand Treasury., 5(9).

Jefferson, T. & Preston, A., 2005. Australia’s “other” gender wage gap: Baby boomers and compulsory superannuation accounts. Feminist Economics, 11(2), pp.79-101.

Munnell, A.H., Aubry, J.-P. & Crawford, C.V., 2015. 15-21 Investment Returns: Defined Benefit Vs. Defined Contribution Plans. Boston College.

Poterba, J., Rauh, J., Venti, S. & Wise, D., 2007. Defined contribution plans, defined benefit plans, and the accumulation of retirement wealth. Journal of Public Economics, 91(10), pp. 2062-2086.

Scott, T.W., 1994. Incentives and disincentives for financial disclosure: Voluntary disclosure of defined benefit pension plan information by Canadian firms. Accounting Review, pp.26-43.

St John, S., 2009. The annuities market in New Zealand. Wellington: Ministry of Economic Development, For the Capital Markets Taskforce Report.

Vidler, S., 2004. Superannuation: choice, competition and administration cost. Journal of Australian Political Economy, 53, p.27.

Worthington, A.C., 2008. Knowledge and perceptions of superannuation in Australia. Journal of Consumer Policy, 31(3), pp.349-68.