FINANCE

FIN 200 CORPORATEE FINANCE MANAGEMENT

Introduction

The tertiary sector employees focus on saving and investing their superannuation contributions for the future security especially in the retirement age. It is required for the employers to contribute to the superannuation or retirement funds on behalf of the employees.

A large amount of superannuation contributions flow to superannuation funds and financial institutions dye to mandated superannuation requirements and belief of the individuals to save the money for future.

In order to make choice for the investment of these funds, there are two options namely investment choice plan and defined benefit plan (Sialm, Starks, and Zhang, 2015). So, it becomes difficult to make select between these options for future investment.

This essay investigates the factors considering in investment choices for superannuation contributions between investment choice plan and defined benefit plan. In addition, it also explains the issues related to concept of time value of money, taxes, opportunity cost, etc. in this decision making process.

Factors in choice of investment plan

Defined benefit plan is related to superannuation policy that determines the benefits paid to the employees at retirement on the basis of formula considering final average salary, age and employed years of the employee (Retirement Benefit = Benefit salary × Length of membership × Lump-sum factor ×Average service fraction).

In this choice, the tertiary sector employees elect the defined benefit plan and pool and invest their superannuation contributions in specified assets that are decided by the UniSuper Ltd. trustees. It means their benefits are decided based on the formula.

It means there is no impact of performance of their asset portfolio on the final retirement payout (Chalmers and Reuter, 2012). The employees cannot get any benefit from gains earned by their asset portfolio.

On the other hand, the Investment Choice Plan allows for keeping the employer-sponsored and personal superannuation contributions and an annual distribution of gains which are generated through their contributions.

However, some charges related to administration and management are deducted in these benefits to the employees. Under this plan, there is a nomination of the type of assets or portfolios by the employee from some strategies including secure fund, stable fund, trustees’ selection fund and shares Fund.

In these choices, there is a major factor is risk-return aspect because secure fund shows the least risk and low return but the shares fund has the highest risk and the highest average return (Fisch and Wilkinson-Ryan, 2013).

Based on this, it can be stated that if the investor or an employee wants to fixed benefits on his/her superannuation contributions, he/she should invest in defined benefit plan.

It provides high stability while making investment their superannuation contributions. So, stability is the major factor that should be considered while making decision related to investment option. The defined benefit plan ensures the stability in the retirement amount for the employee (Langley and Leaver, 2012).

On the other hand, the flexibility is a factor that needs to be considered while making investment decision for the superannuation contributions in investment choice plan and defined benefit plan.

It is because the option of the investment choice plan provides flexibility to the employee to choose different strategies as per their needs and requirements.

This option provides flexibility in terms of choosing any strategy among secure fund, stable fund, trustees’ selection fund and shares Fund that vary as per the relative risk and returns for the employee on investing their superannuation contributions (Morrin et al., 2012).

Moreover, the direct benefit plan ensures the payment to the employees at established payment cycles. For selecting this option, different factors including final salary amount of the employee, age at retirement, number of years employed and the contributions amounts from the employee.

This option is sponsored by the firm as there is management without inputs made by the employee. The amount paid to the employee is taxable at the beginning of the benefits (Turner, and Klein, 2014).

The ratio of funds invested determines the increase in value of the plan for the employee. On the other hand, the investment choice plan is different and provides control to the employee to choose the investments to invest their money for retirement.

There is no need to be worried for the investment returns of the employees invest in the defined benefit plan (Blake, Wright and Zhang, 2014). But if the employee wants to take risk and earn high, then the selection of the investment choice plan can be significant.

Concept of time value of money, taxes, opportunity cost in decision making process

Time value of money, taxes and opportunity cost play an important role in determining retirement plan. It is because investment decisions are made based on the future aspects.

So it is crucial to determine the futuristic perspectives like time value off money. The duration of time may impact the benefits as well as costs that depend on the probability of their occurrence and value. It means the time has an influence on the value because the time impacts the liquidity.

The impact of time on the liquidity of the money and its value can be referred as the time value of money (Gerrans and Clark, 2013).

Due to influence of external environment including economic conditions, inflation, interest rate, and changes in global economy may have a significant impact on the value of the money in future that can also affect the investment returns for the investors.

In this case, employees are the investors as they are intended to invest their superannuation contributions to the retirement plans like defined benefit plan or investment choice plan; they need to consider the future value of money.

Investment decisions can be proved wrong due to uncertainty of the future that raises the need to consider those factors to make the best decision (Mohan and Zhang, 2014).

Evaluation of alternatives like defined benefit plan and investment choice plan involves the speculation on the results and also value of the results that will occur in future.

So, it is required for the employees to understand the risks and uncertainties that may be possible over the time and also opportunities that may cause opportunity costs along with the time. Therefore, time value of money matters in the invetsent choice plan.

It is because there are not defined benefits for the employees. The returns in this plan don’t depend on the investment planner as these are decided by the market conditions and economic certainty.

If there are some changes in the economic conditions then it may impact the returns in the investment choice plan.  So it matters for the employees to consider time value of money in the investment decisions for the retirement especially in investment choice plan rather than the defined benefit plan.

However, there is no significant impact of the economic uncertainty with the time on the returns obtained in defined benefit plan (Langley and Leaver, 2012). So, employees need to consider time value of money while taking the investment decisions for the retirement.

In this plan, employee can lose the value over the tie due to possibility of interest risk, inflation, and market uncertainty. If the employee invests wisely then he can realize the gains like the direct benefit plan over the time.

At the same time, the fee to exchange the currency along with the time also causes the transaction cost that is related to the trade or investment. It also takes time that may create opportunity cost.

It means the employee will not be able to exchange the money for some reason that will cause cost more than the expected value. So, obtaining liquidity for the investment may cause transaction costs, opportunity costs and risk (Merton, 2014).

In the selection of the investment choice plan, there is opportunity cost because if the employee has the liquidity now, he/she can use it for the consumption or investment and get benefits from it now. But there is always some uncertainty regarding the future that may impact the future returns.

So it can be stated that the opportunity cost plays an important role in determining the investment choices for the retirement plans. It means time causes distance between the investor and the liquidity of the investment value so it creates costs taken away from value.

Overall the time has the impact on the total wealth earned on investment (Mitchell and Utkus, 2012).

On the other hand, taxes have also a significant impact on the choice made between defined benefit plan and investor choice plan. In the defined benefit plan, there are two options including tax-qualified benefit plan and non-qualified plan.

A tax qualified plan allows the employer and beneficiaries to make additional tax incentives that are not present in nonqualified plans. But in investor choice plan, the investment is typically tax-deferred I which the employee contributes fixed amount or percentage of paybacks to fund their retirements.

In addition, employer will also add the same portion of employee contributions to the employee.

However, in these plans, the withdrawals are not tax free. Tax advantages in the defined contribution plan allow for growing the balance larger as compared to taxable accounts in investor choice plans (Blake, Wright, and Zhang, 2013).

So, taxes also play an important role in determining the investment options between the defined benefit and investor choice plans by the employees to get the tax advantages.

Conclusions

Based on the above discussion, it can be stated that there are different factors that should be considered while making investment in retirement plans for superannuation contributions including defined benefits plan and investor choice plan.

Final average salary, age and employed years of the employee are the major factors in the returns for the defined benefits plan as there is no significant impact on the returns on the employee benefits.

But in the investor choice plan, there are different options for investment that are based on risks and returns on the invested value. With the fraction of the risk and return, the employee can invest their superannuation contributions to the retirement plans.

At the same time, it can be concluded that stability, risks, and flexibility are considerable aspects while making decisions related to investment in retirement options.

Apart from this, it can also be summarized that time value of money, opportunity cost and taxes have a significant impact on the selection of retirement plans because all these factors have a considerable impact on the investor choice plan rather than defined benefit plan.

Over the time, there may be changes in economic conditions that may affect the wealth or returns on the investment in investment choice plan.

Recommendations

Before making investment in retirement plan, it is necessary for the employee to consider above discussed factors to decide the particular options as per the requirement and needs.

It is necessary for the employee to understand the relationships between the time, risk, opportunity risk and value due to their impact on the profit obtained from the investment in retirement plans.

It is also crucial to know for the employee what the future cash flows will be after investment. In addition, when the future cash flows will be obtained and the rate at which time has an influence on the value should be determined the employees before making the investment in retirement plan.

If someone wants stability, then he/she should opt for the defined benefit plan but if someone wants to earn more and accepts the flexibility in terms of risk and returns then the selection of the investor choice plan is significant.

Apart from this, opportunity cost should be considered in selection of both options of retirement plan. It helps to keep the costs low in investment and maximize the returns for the investors.

References

Blake, D., Wright, D. and Zhang, Y., 2013. Target-driven investing: Optimal investment strategies in defined contribution pension plans under loss aversion. Journal of Economic Dynamics and Control37(1), pp.195-209.

Blake, D., Wright, D. and Zhang, Y., 2014. Age-dependent investing: Optimal funding and investment strategies in defined contribution pension plans when members are rational life cycle financial planners. Journal of economic Dynamics and Control38, pp.105-124.

Chalmers, J. and Reuter, J., 2012. What is the impact of financial advisors on retirement portfolio choices and outcomes?. Available at SSRN 2078536.

Fisch, J.E. and Wilkinson-Ryan, T., 2013. Why Do Retail Investors Make Costly Mistakes; An Experiment on Mutual Fund Choice. U. Pa. L. Rev.162, p.605.

Gerrans, P. and Clark, G.L., 2013. Pension plan participant choice: Evidence on defined benefit and defined contribution preferences. Journal of Pension Economics & Finance12(4), pp.351-378.

Langley, P. and Leaver, A., 2012. Remaking retirement investors: behavioural economics and defined-contribution occupational pensions. Journal of Cultural Economy5(4), pp.473-488.

Merton, R.C., 2014. The crisis in retirement planning. Harvard Business Review92(7/8), pp.43-50.

Mitchell, O.S. and Utkus, S., 2012. Target-date funds in 401 (k) retirement plans (No. w17911). National Bureau of Economic Research.

Mohan, N. and Zhang, T., 2014. An analysis of risk-taking behavior for public defined benefit pension plans. Journal of Banking & Finance40, pp.403-419.

Morrin, M., Inman, J.J., Broniarczyk, S.M., Nenkov, G.Y. and Reuter, J., 2012. Investing for retirement: The moderating effect of fund assortment size on the 1/n heuristic. Journal of Marketing Research49(4), pp.537-550.

Sialm, C., Starks, L.T. and Zhang, H., 2015. Defined contribution pension plans: Sticky or discerning money?. The Journal of Finance70(2), pp.805-838.

Turner, J.A. and Klein, B.W., 2014. Retirement savings flows and financial advice: should you roll over your 401 (k) plan?. Benefits Quarterly30(4), pp.42-54.

Leave a Comment