OVER the past to years defined contribution plans have gained significant prominence in the Irish pension arena. In particular, the majority of new plans set up today are of the defined contribution rather than the defined benefit type.
Generally, the more mature pension plans tend to be defined benefit plans, whereas the smaller and more recently established arrangements tend to be defined contribution plans.
What's the difference between defined contribution and defined benefit?
The more traditional method of pension provision in Ireland is the defined benefit plan. In this type of arrangement, the benefits which a member expects to receive are defined in some fixed way, generally as a function of salary and service. For instance, member's pension at retirement could be defined as 1160th of the member's final salary at retirement for each year of service.
In a defined contribution arrangement the amount of contribution is fixed (perhaps as a percentage of salary) and the ultimate benefits payable depend entirely on the fund that builds, up from the investment of these contributions.
What are the advantages of defined contribution plans?
The main advantage of a defined contribution plan from the point of view of the employer is the ability to control costs. Since contributions are defined, the cost of operating the plan is known both in the short term and in the long term, relative to the salary cost. There is no obligation on the employer to increase the contribution rate in the light of poor experience in investment, salary increases or demographic movements in plan membership.
For the employee, defined contribution plans facilitate greater flexibility in deciding benefit structures to suit individual circumstances. The more transparent and portable nature of the benefits also facilitates' job mobility. There may also be an element of choice in the way the contributions are in vested. Defined contribution plans also facilitate a greater sense of ownership and understanding by the employee of the pension arrangements. What are the disadvantages?
The main disadvantage is that the investment funds built up from the employee and employer contributions may not be sufficient in the long run to provide all members with the level of benefits that they had anticipated. This could result from adverse investment conditions at retirement or higher salary increases in the latter part of an employee's career. Allied to this is the fact that it is only possible to estimate the level of retirement income under a defined contribution plan.
In essence, defined contribution plans switch the responsibility and the investment and interest rate risk from the employer to the employee.
Why is there a trend towards defined contribution plans?
There is no doubt that for new companies, or companies setting up pension arrangements for the first time, the use of the defined contribution approach allows the employer to provide pension benefits in a way that satisfies their employees without exposing the employer to increased costs in the future.
Generally speaking, the average age of employees in new companies is relatively low. These employees are also much more likely to have a number of different jobs during the course of their careers. As a result, the flexibility of the defined contribution approach is valued more highly by the employees in these companies than the potential adverse implications of poor investment performance.
Many of the new plans being set up in Ireland are for US and other multinational subsidiaries. In the US in particular, defined contribution pension arrangements are commonplace and have worked well for many years. For these companies, therefore, the natural extension is to apply this approach in Ireland.
We are even beginning to see the use of "flexible benefit" approaches for US multinational subsidiaries, a concept which fixes the total to be spent on a range of employee benefits (pensions, VHI, etc), but gives employees choice. Another factor which has accelerated the trend towards defined contribution arrangements is the Pensions Act 1990. This Act introduced appropriate safeguards to ensure the professional management of defined benefit and defined contribution plans.
Looking forward:
We expect that the majority of new plans will continue to be set up on a defined contribution basis. However, great care is needed to ensure that the defined contribution approach is fully understood by both employer and employee, not only in terms of its implications for employees in the short term, but also the risks that are apparent in the longer term.
New trends in employee benefit provision, such as the flexible benefit approach will tend to favour defined contribution plans. These trends may lead to a movement away from defined benefit arrangements, even for existing plans. So, defined contribution plans are here to say.
