Monday, February 23, 2009

Pension as part of your investment decision-making

Firms tend to offer either or both the two types of pensions schemes:

Defined benefit: Employer pays into a pension scheme that pays the employee a pre-stated benefits package with the most generous giving a 2/3 of salary as lump-sum payment plus a fraction of your salary for the rest of your life. Generally seen as very generous.

Defined contribution: As per the cover, the employer pays a pre-stated % of your salary (the most generous is 15%) into a money purchase scheme that is managed by pension fund manager who is selected by the employer. There does tend to be certain variations in that some employers only match what the employee puts in and so forth. Otherwise known as 401k in the US.

A combination of events has reduced employers' appetite for funding defined benefit pension schemes. Market volatility, older population, shorter employee durations have removed the case for supporting such schemes. The first time firms started announcing that they were closing defined benefit schemes, employees and especially the unionised type protested greatly. However the introduction of DC schemes that allow the employee to choose the investments is changing this mindset.

Placing the onus on employees to make the correct investment decisions for your pension is I think one invention I've really appreciated. Your employer tells you that they will invest a % of your salary. Its then upto you to choose what you want to invest the funds in. Yani make 20year decisions today. The typical way is to try and align your investment with your risk appetite which is what investment/financial planners will tell you to do. However, your thinking should rather be about what your goals are i.e. when do you want retire, what do you want to do when you retire, what sort of lifestyle do you want to enjoy when you retire and so forth. In all cases, one has to remember that at a retirement age of 55yrs, you are looking to finance your life for anything upto the next 45yrs. Pension decisions should also be done within the context of other investment decisions. After all, the pension will tend to be allowed 15% of your salary.

PS: In either DB and 401k, you generally don't get anything if you leave within the first 2 years. Apart from your own additional contributions which you can do to either. Over above this period, you can either carry the same to your next employer (preferred choice) or keep it with the old employer.

PPS: A pension scheme is no more than a unit trust fund.

Self employed and the unemployed:

If you are self-employed or unemployed, you can set a personal pension plan into which you invest when you are able to do so. The important thing is to set such a plan. Its sometimes possible to carry your plan into future 401k plans.


Ssembonge said...

Very informative post considering a lot of minorities ignore issues such as retirement savings because it is something new for them and often confusing.

Here in the US, most schemes vest after 5 years. But for people in very skilled jobs or executives, the schemes might have a short or no duration to vest.

I've got both. The DB vested after 5 years and the DC after 2 years.

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