DISTINCTION BETWEEN DEFINED CONTRIBUTION FUNDS & DEFINED BENEFIT FUNDS

1. DEFINED CONTRIBUTION FUND:

A defined contribution fund is a fund that provides benefits on retirement that are based on the accumu-lated contributions made to the fund by the member, employer (if any), as well as the investment returns earned by these amounts. Expenses incurred in the management and administration of a fund can be levied directly from contributions or from the in-vestment returns earned by the assets of the fund.

The member and employer contribution rates are fixed and are specified in the Rules of a fund. Each participant (member) in the fund is assigned an indi-vidual account to which the contributions (employer and/or employee), any returns and their proportion-ate share of the expenses are allocated. Risk premi-um expenses, i.e. those expenses incurred to secure the provision of death and disability benefits may also be defined in the Rules. Retirement benefits are not guaranteed because the members’ benefits are subject to the fluctuations in the performance of the fund’s investments and other risks.

Advantages:

• The value of contributions paid by the employer and the member;

• The performance of the underlying investments in the fund;

• Administration costs; and

• Prevailing annuity rates at the time the pension is taken.

Benefits:

• Higher pension at retirement compared to a defined benefit retirement fund if the fund

portfolio performs well and yields a good investment performance;

• Guaranteed full benefit pay-out on retirement if the fund manages its risks;

• Flexibility offered to choose investment cat-egories, which is generally equity and fixed income; and

• It is easier to understand the concept of defined contribution funds than the defined benefit funds concept.

Disadvantages:

• The members benefits are exposed to investment risk;

• There is no guarantee that the members’ pen-sions will keep up with inflation; and

• The members are not in a position to know their ultimate pension reserves.

2. DEFINED BENEFIT FUND:

A defined benefit fund is a fund that provides a ben-efit upon retirement that is determined by a formula set out in the Rules, based on the employee’s earn-ings history, tenure of service and age. The rate at which the member contributes to a fund is usually fixed as a percentage of that member’s remunera-tion. The employer’s rate of contribution is usually determined by the amount that is required by the fund to ensure that it meets its obligation of paying benefits to its members as and when they arise.

An actuary computes the rate at which the employer will be required to contribute in order to ensure that the fund meet its liabilities. Unlike a defined contri-bution fund, all contributions and assets in respect of all the members are “pooled” together and benefits are paid from this pool as and when they become due.

Provisions are made in the funds’ rules for deduc-tions to be made from the contributions made by the employer and employee to pay for costs related to the administration and management of the fund. Risk premium expenses, i.e. expenses incurred to secure the provision of death and disability benefits may also be defined in the Rules.

Advantages:

• The members’ exposure to investment risk is borne by the employer and therefore all things being equal, members are guaranteed to get their benefits; and

• In some instances the members’ benefits can be extended to a spouse, depending on the type of retirement payout that the members choose.

Disadvantages:

There are no guarantees that your pension will keep up with inflation as increases are at the discretion of the trustees and dependent upon the investment returns within the fund:

• Trustees can retain part of the investment re-turn to build up a surplus in the fund, but this would not affect the benefits at retirement;

• In certain instances, the member’s final salary is extremely important and can have a major impact on your total benefit; and

• The employer has open-ended liability on contributions.

General Comments:

Although both pension fund arrangements are cur-rently used in Namibia, the majority of pension funds in Namibia are defined contribution funds. With defined benefit funds, the employer assumes the market risk, which can be either good or bad. During periods of economic growth and rising asset values, the cost of funding (i.e. contributing money to the fund and investing it to accumulate funds nec-essary to pay the pensions when employees retire) a pension decreases as the rising values of the invest-ments enable the employer to contribute less out of current revenues and still build the value of the fund to cover future pension obligations. However, when markets go down and asset values decrease with them, the employer is forced to pump more money into the fund in order to meet future obligations to the retirees. This means that members are guaran-teed to receive the benefits as outlined by the formu-la regardless of the market conditions.

The members, particularly the retirees, are not harmed as their income does not decrease, but they also do not receive any benefit (in terms of their pension income) from the economic growth. When inflation drives market values up, the employer again benefits by being able to maintain the month-ly pension income for the retirees while paying less money to do so. The retirees, however, are harmed because, while pension income remains constant, the purchasing power decreases, thereby reducing their standard of living.

“The worldwide trend among employee-spon-sored pension funds is towards defined contri-bution funds.”

With defined contribution plans, market risks and re-wards are reversed as the retirees assume most of the risks and reap most of the benefits. When economic growth causes investment values to increase, the re-tirees see their wealth and income increase, while employers are unable to adjust their contributions downward. Similarly, when inflation causes invest-ment values to rise, employers are again unable to adjust their contributions while retirees see the mon-etary value of their pension funds rise. While infla-tion-induced increases in pension values and income generated by these rising values don’t increase the retirees’ spending power (as all prices in the econo-my are increasing due to inflation), the inflation-in-duced increases in their pension values and income offset the rise in prices, thereby allowing their stan-dard of living to remain unchanged.

Conclusion:

Both pension arrangements have advantages and disadvantages and strong arguments can be made for both. The worldwide trend among employ – er-sponsored pension funds is towards defined contribution funds as they do not have to as – sume the market risk. All things equal, the choice of pension fund depends on whether the employer or the members wants to assume the investments risk (and inevitably the reward).

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