Category: Finance

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Retirement Plans

Introduction

During the past three decades the retirement plans have shifted from Direct Benefit (DB) to Defined Contribution (DC).The trend is seen in both public and private sectors. The DC plans transfer much of the decisions like the investment and savings from the employer to the employee. The DC plans have attracted the employees in terms of their flexibility and portability.

The mentioned benefits come with the responsibility to choose in a wise manner. The plans have also provided the economists to study the saving behaviors of the individuals. In developed countries like US the plans have expanded themselves to several other factors like health care and time-off arrangements. Due to their wide adoption they have been implemented in different countries including Latin American Nations, Germany, Sweden and Russia.

As the power of decision is given to the individual it is assumed that the employee will behave as an active economic agent acting to maximize its self-interest.  According to this implicit assumption it is assumed that the individual can interpret and judge the information presented as options from employees and governments. The individual is able to evaluate and balance the choices offered to him and can reach an informed decision.

In the recent years it is seemed that the people when trying to maximize the profitability make decisions which have less outcomes as expected. According to the studies the individuals have the right intention but they lack in the abilities to make necessary changes in the behavior. The philosophy of the people making such decisions has developed the rapidly increasing fields of behavioral economics and finance (Utkus et.al, 2003).

b) Purpose

This research will focus on the question of behavior adopted by the individuals while making economic decisions and the reaction of the market towards these decisions. In the research it will be analyzed that how the workers make decisions to save, manage the retirement investments and how they address their assets in retirement. The choices of making decisions have some consequences which are planned to be evaluated in this research. The research questions are as follows:

1. Are the employees well placed and informed about the plans offered by the employers or the governments?
2. How the DC plans are implemented in the various countries?
3. How the employees made decisions regarding their retirement plans?

Literature Review

Defined Contribution (DC) Plans in Various Countries

Stakeholders in the employment sector have an obligation of ensuring that retired employees attain the capacity of enjoying lifelong financial security. However, the approach of how and when this can be achieved remains a wide subject of discussion. Different nations across the globe adopt different mechanisms of implementing their policies regarding saving for the future. Defined contribution (DC) is one of the most adopted approaches of enhancing the employee saving concept for future financial security.

Edwards and Webb (2015)defines Defined Contribution as a retirement plan sponsored by the employer, which puts into account several factors like employee salary history and period of services. Under this scheme, the company exercises entire control of the investment risk and management of portfolio. According to Edwards and Webb (2015), the success retirement scheme is dependent on the input of the plan, levels of saving, and performance level of investments provisions relative to particular benchmarks.

However, these metrics do not sufficiently address the plans potential in providing employees with adequate retirement income. Similarly, there are several challenges, which the responsible institutions of implementing retirement schemes face in the line of deciding the most suitable retirement plan to employ (Beshears 2012). As a result, different countries employee employ different schemes suitable for the needs of its employees.

The objective of this paper is a literature review addressing how different countries implement defined contribution policy. This study also presents a discussion on the relevance of the said retirement plans and contribution schemes and some of the areas, which needs to be addressed to meet the needs of the participants.

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 Implementation of Defined Contribution plan

Defined contribution plan is a retirement benefit policy adopted by most countries across the globe. For instance, the most adopted employer-sponsored retirement plan in the US pension system is the use of DC plans with 401(k), 403(b) plans, 457 plans among others (Brown 2016; Weisbenne; 2016). According to the 2010 annual report by then US Department of Labor, approximately 73.4 million citizens are members of the defined contribution plan of which 401(k) plan cohabits 60.5 million participants.

The 401(k) plans consists of various attractive characteristics for long-term participants, which includes deferral of tax, flexibility and portfolio control (Miller2015). The scheme provides for the delay of taxes on income and interests until the contributors start getting distributions from the scheme. Rollovers such as the transfer of 401(k) funds into an alternative competent scheme or a self-employed retirement plan can be done easily under this scheme.

This scheme caters for large participant expenses such as emergency loans and medical expenses. Furthermore, employees can be given a lump sum amount of their contributions when the saving period comes to an end.  In case an employee decides to withdraw from the scheme, the employer is provided for by the law to retain 20 % of the distribution. However, in case of rollover to another scheme, the employer is required to transfer 1005 of the contribution.

Despite having attractive features, 401(k) the idea of increasing the rate of tax when deferring tax using a 401(k) may be considered unfavorable by the employees (Adkins 2016). Besides, participants may be frustrated by restriction to utilize their shares before the end of retirement period. Similarly, the 401(k) scheme limits participants to a particular amount of annual contribution, which stops automatically, in case they are forced out of work as a result of becoming disabled.

Adkins (2014) observes that, while there have been many structural improvements on the features of 401(k) scheme, there are several problems, which needs to be addressed. Adkins argues that the problems concerning structural flaws, horizons of long investment period, high administrative costs, lackluster keeping of records should be addressed. In addition, the providers of the plan should also look into the issue of sub-Par investment plan model and options of Marginal Quality Investment as well as implications of complex tax.

According to the overview of the Canadian Pension Plan (CPP), a person or the family is entitled to partial earnings replacement after retirement, disability, or death. Regardless of place of residence, one qualifies for a pension from the country of residence. Almost every working citizen in Canada contributes to the Canada Pension Plan. However, Brown (2016) observes that, most of the employees in current generation are not saving enough towards secure retirement benefits.

Besides, in a define benefit plan, employees are only entitled to income when they die, therefore their claim for further pension assets stops when the contributor dies. Nevertheless, under some provisions, the surviving dependents like a spouse can claim the asset. Therefore, Brown recommends that the scheme be upgraded to a defined contribution plan to address this problem.

Under a defined contribution plan, participants are not promised of any retirement benefit stream. Instead, an employee contributes a certain defined amount towards building a personal fund, which develops a financial asset portfolio for generation of retirement income. The participant decides on the investment approach from a wide range of options. However, according to Kolivakis (2015), the defined contribution approach is associated with various problems.

Among the limitations of this scheme is that, in some cases, the funds offered to  workers is relatively high leading to insufficient returns. Secondly, the employees have picked unsatisfactory weightings of the portfolio particularly regarding the employer’s shares, which may turn disastrous incase the firm fails. Besides, the employees are not well vast with how large their contribution should be.

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Nonetheless, Kolivakis (2015) states that the above problems can be addressed through a well define retirement plan. He suggests that the scheme provider should ensure a reasonable allocation of expenses and portfolio. In addition, the sponsor should also ensure that the amount of contribution is adequate to realize the promised benefits (Jefferson 2011)

However, there has been a massive move-out by the private sector on the basis that there are extremely difficult to sustain in the present employment environment. The government is reluctant to chip in its support citing hidden political risks as the main reason. Compulsory pension benefits provisions

On the other hand, defined contribution is mandatory government requirement for all the citizens. For instance, the Malawian legislature enacted a pension act in 2011 and the 2010 employment amendment act to call for citizens to subscribe to retirement benefit schemes. According to Mhango (2012), the driving force behind these legislations was to ensure every employer provides a retirement plan for its employees by facilitating their membership to the national pension scheme.

In addition, the pension act also provides the minimum subscription amount that each employee should contribute. However, Coleman (2011) argues that the mandatory pension scheme is inconvenient for some people, who are forced to save at the time when it is not within their priority. Besides, participants are limited to invest in some assets, which are not of their preference.

The U.S for instance, is one of the nations that has adopted employer-sponsored retirement plan pension system with the use of DC plans with 401(k). However, some scholars argue that while there have been many structural improvements on the features of 401(k) scheme, there is still a lot to be done to make the scheme a completely inclusive. Adkins argues that the problems concerning structural flaws, horizons of long investment period, high administrative costs, lackluster keeping of records should be addressed.

An overview of the Canadian Pension Plan (CPP), states that a person or the family is entitled to partial earnings replacement after retirement, disability, or death. However, it is argued that in a define benefit plan, employees are only entitled to income when they die, therefore their claim for further pension assets stops when the contributor dies.

Besides, the limitation of this schemeis that, in some cases, the funds offered to workers are relatively high leading to insufficient returns. In some nations, the working citizens are by law required to subscribe to national pension plan. However, the disadvantage with this initiative is that, it may be inconvenient for some people, who are forced to save at the time when it is not within their priority.

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Employees understanding plans offered by the employers or the government

Employees benefits are the primary tool by which employers use to attract and retain qualified and experienced employees in an organization. Other reasons include; promotion of higher levels of morale among employees, aligning employees’ benefits with competitive offers in the market, providing promotional opportunities as employees move to other positions within the organization or when they retire and so on.

All over the world, employees’ benefits are categorized into two.  The first category is about those that are required by law which aims at providing the most essential and important needs of employees and /or their families. They include; workers compensation, social security, unemployment insurance and others.

The second category is those that the employer offers voluntarily to compensate employees. They include a wide array of programs like; Life Insurance, defined benefit Retirement plan, Health care insurance, paid jury, paid funeral leave, Unpaid family leave, Vocational pay, Holiday pay, Employee assistance programs, Dental care, Flexible compensation, Health care insurance, Paid military leave, Subsidized commuting, Flexible work place, payroll deduction IRA, Wellness programs, dependent Care Reimbursement care account, Long term Disability, Short Disability, Paid family leave, Paid personal leave, Childcare, Stock options and many others. The reasons to why most employers voluntarily offer such benefits range from a desire to be more competitive in the labor market to a genuine concern for their employee’s wellbeing.

Employees benefit plans plays an important role in the lives of employees. As such, the benefits offered by employers can be a deciding factor for a potential employee’s decision to work for a given employer. Most employees seek to know what they will get before they decide whether to accept an offer or not.

Most employees are aware of the plans offered to them by either the employer or the government. For example, most employees prefer medical insurance, paid leave and retirement plan. If you deny them, they will easily head for the door when another opportunity that promises to offer them knocks.

Most of the employees are aware of the government benefits plans. For example, every employee is aware of social security of which every employer pays at the same rate paid by their employees.

Other benefits plans provided by the government. For example, workers compensation, and unemployment insurance are a must and therefore, employers and maybe the government will ensure that all employees are aware of such benefits. The employer will take the first step by not only ensuring that employees are aware but also complying by availing them to employees. A fail to do so may impact their business negatively.

During interviews for a new job, most employers inquire more on the kind of benefits a prospective employee would prefer. Such a question would not be asked by an employer when they know that a prospective employee is not aware of such kind of benefits. 

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Although the law does not require the employer to offer a retirement program to his/her employees, if offered, it must be fully and well disclosed to employees. As such, the employees are made aware since the terms and condition of a retirement program are enforceable in some countries. More specifically, in California courts.

Most employers disclose all kind of benefits they will be offering to a new employee on the contractual letter. At this point in time, the new employee is made to know what kind of benefits her or she will be enjoying and vice versa.

All human beings fall sick at some point in their life time. Although it’s an unfortunate situation, a reasonable employee knows whether he or she like it or not, he or she will once fall sick. As such, an employee will definitely inquire from an employer if they provide a sick leave or not. Some employers will disclose such details during appointment.

Although most of the employees are made aware of the benefits plans they will or are entitled to by their respective employers, some employees who are not keen enough may to some extend not be aware of some benefits they will or are entitled to due to their ignorance.

Other employees simply do not mind some of other benefits their employers may or are offering apart from their normal salary or wages but majority of employees are aware.

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Employee choice of retirement plans

Making decision on when to retire may be one of the greatest decisions an employee makes during his lifetime. The decisions on retirement can significantly affect an individual well-being for many years. Many researches about retirement decision have explored the impact of health NIA (2007) and economic status, Gustman and Steinmeir (2002) on person decision to retire. Research shows that individuals with poor health, or whose family member or loved ones are experiencing negative health conditions, retire earlier than those in better health (McGarry 2002).

The role of the state, local government and private sectors as employers is simply to hire the right kind of employees to provide the best value services to the public or customers. It is not the responsibility of the employers to plan and prepare the employees for retirement. The truth that some individuals will make poor decisions in their retirements planning does not change this.

People still make bad decisions in their marriage and how they raise their children, but no one is suggesting that employers should intervene and make decisions for the employees.  The financial services industry has invested a lot in innovating to provide the services that their clients’ needs. There are reputable financial advisors throughout the country in case an employee requires a financial advisor. If employees require an estimate amount they want to save, there is a calculator tools on internet.

In case they want low cost, diversified investments, there various company that provide this. In case of guaranteed life time income, there multiple insurance firms that offer annuity income. If employees do not use all these services, then they really do not need them. If people want to spend the money today and forget tomorrow, who then is the employer to say their decisions are wrong.

Many employees have a low level on financial knowledge, especially when it comes to retirement planning. Sometimes the employer can provide a valuable guidance and education to its employees on the matter regarding finances and retirement. These services will not only be valuable to employees but also the employers because financial problems are major distraction from work and absenteeism. Through helping employees prepare for retirements, employers enhance smooth transition from order employees to young employees.

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Through education, employees learn financial skills that will help them plan throughout their lives. Through working with an advisor, employees are able to alter the benefits to the certain needs of themselves and their families. Education and guidance have been proven to work and increase the employee’s saving rate. When individual decide to retire, they must have a method to support themselves financially, as their previous income from work will no longer be available.

Hence the question of how to support oneself should be a great consideration in retirement decision. Commonly, income during retirement is thought to come from personal saving, pension and social security benefits. Many employees fail to consider the matter of financial well-being in retirements until retiring become imminent (EBRI 2008).

Creating decision environments that enables people to make the best choices possible is the objective of careful choice architecture which can be used to “nudge” (Thaler and Sustein 2008) retirees toward retirement decisions that are beneficial to them. In such a case, behavioral decision making research can guide the ways policymaker and retirement advisors communicate with potential retirees.

The findings from behavioral decision making research also innovate new ways to approach matters surrounding the retirement’s decision. For instance Featherstonehaugh and Ross (1999) argued that providing retirees with the option to receive a one time, lump sum benefit could encourage delayed retirement. After the survey research, majority of respondent claimed that one-time, lump-sum payment provided a greater incentive to delay the retirement, this compared to Standard Social Security annuity increase.

When deciding when to retire, employees compare what their lives would be like under different scenarios. There also some trade-offs that employees may make when thinking about retirement; more comfortable life now, less money later, working longer now, a good retirements benefits later. An important prerequisite of the retirement decision is the accuracy prediction of one’s future emotions.

There are ways individuals use to help them make accurate predictions of their future well-beings, but sometimes cognitive biases lead to erroneous predictions (Hsee and Hastie 2006). Often errors can be caused by the impact bias (Wilson and Gilbert 2003), it describe people tendency to overestimate the duration and intensity of their emotions in reaction to negative and positive future events.

Understanding the role that affective forecasting can contribute in the retirement decision may be important for recognizing why individuals retire when they do. The same way patients mentally simulate the experience of receiving a mammogram before deciding to make an appointment, just the same employees mentally simulate how retirement would be like before even deciding to retire.

Gilbert and Wilson (2007) discuss four characteristic of affective forecasts and explained why those characteristic mismatch between mental simulations and actual experiences. They argued that the mental simulations are unrepresentative, essentialized, abbreviated, and decontextualized. Unrepresentative, means they are formed from memories of past events that does not display how future events will unfold.

People tend to remember the best and worst of an event, as well as the final part of it, neglecting the instances that were simply average (Kahneman 1997). Therefore when thinking about retirement individuals may form mental simulations of future work experiences using their best and worst work related memories.

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Mental simulations are also essentialized, which means that they only hold the main features of the events but not minor details. This may involve thinking about aspects of one’s job, such as feeling undervalued by a boss, while forgetting details such as interacting with coworkers. Mental simulations are also abbreviated, meaning they are shorter than the actual event being simulated. When thinking how retirement would be, an employee is likely to consider only the early stages of retirement.

Decontextualized, means that the contextual factors present during mental simulation of the future may not be present at the time the event actually occurs. For example when an employee decides to retire, they are earning an income that will not exist once theyretire. At this moment the individuals are not feeling the strain of limited income, and the situation in which they are simulating retirement will not include negative feelings associated with inadequate funds. All of the mentioned features of mental simulations may lead to inaccurate affective forecasts of retirements.

Workers may prefer to retire early both because they think working longer will be worse than it is and life after retirement would be better. Everyday throughout the world employees are preparing or finishing planning their retirement plan. There much to look into when organizing a plan so that you can meets your retirement goals. Most employees focus on what stock and bonds they would wish to invest in and also about 401k. 

Employees find it difficult to determine which kind of stocks they would want to invest in. There are many different stocks in the stock market, therefore making it difficult for people to choose the best. Another problem would be kind of bonds they would also like to invest in. Investing in both stock and bonds does not make the individuals rich but use their money wisely as they near their retirement age.

Old age most of the time brings medical problems and health expenses. Without your own saving, living your younger years in comfort while also minding to cover your medical expenses may be a large burden to bear. To prevent any unforeseen sickness from eating on your retirement savings, you may consider obtaining insurance, such as medical and long term care insurance.

This will finance any health care that may arise. Employees considering retirement could be asked to write down the events that go down in a normal working day. This activity will help the employee paint accurate and complete picture of how it would be to worker much longer and without missing the minor details that somehow make their work more enjoyable.

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Methods

This study aims at assessing behavior adopted by the individuals while making economic decisions and the reaction of the market towards these decisions. Quantitative analysis was used to assess the correlation between dependent as well as independent variables. Understanding behavior adopted by the individuals while making economic decisions is vital when it comes to addressing the research questions of this study.

The study used quantitative technique to assess the gathered information. Different behavior adopted by the individuals while making economic decisions can be estimated by data. Information associated with behavior adopted by the individuals while making economic decisions can provide a detailed understanding regarding how DC plans implemented by various nations; decisions workers make about their retirement plans; and if employees are well placed and informed about the plans offered by the employers or the governments.

Data collection techniques

The purpose of this study is tobehavior adopted by the individuals while making economic decisions and the reaction of the market towards these decisions. The study also highlights on the how workers make decisions to save, manage the retirement investments and how they address their assets in retirement.

Data description

Much as plan-level information is an effective technique to assess the behavior adopted by the individuals while making economic decisions, a number of them are ineffective when it comes to analyzing the effect of how the workers make decisions to save, manage the retirement investments and how they address their assets in retirement. As such, survey data can address these challenges, such that it involves defined contribution plans with or without investment decisions.

This study embraces first wave from HRS, which is a household survey that was initiated in 1992. Moreover, detailed demographic information of the participants, supplementary issues, the spouse’s pension eligibility and benefits from present or previous employer or other sources of pension integrated in the questionnaire. Owing to the fact that survey technique is of elderly population, the sample does not represent pen-age group, particularly, the sample of elderly group and hence assessing this data cannot adequately depict behavior adopted by the individuals while making economic decisions.

Some characteristics of contribution degree must be highlighted. For instance, various employers offering plans require a default level of contribution rate for workers, in other words, individuals who choose to use DC plans must automaticallycontribute the default rate of their wages. However, without such data, it becomes challenging to evaluate the actual rate of contribution for individuals desiring to make contribution between 0 and default rate.

Again, employer-funded DC plans impose a maximum level of worker’s contribution. For that reason, if the individual contributes maximum rate, the desired contribution is likely to increase in comparison to the reported rate of contribution. The employer also offers certain percentage to workers’ contribution, however, to a certain proportion of salary.

This is widely known as match threshold. A number of people save in the retirement plans in terms of the amount of match threshold, which is the regarded as initial rate of rate. Nonetheless, HRS does integrate these questions, which can address the default level of contribution, match threshold and maximum amount

Regardless of these limitations imposed on individuals, they have the right to save, manage the retirement investments and how they address their assets in retirement. Firstly, individuals can chose to contribute positive rates or any amount between default or maximum rate. Moreover, individuals can contribute a higher figure that what employer or government match threshold.

This research concentrates on the aspect of workers position in terms of making informed choices regarding plans offered by the employers or the governments; implementation of DC plans in different nations; and the way in which employees make decisions regarding their retirement plans.

The decision to save, manage the retirement investments and how they address their assets in retirement used in this study is reported data by individuals in HRS. This is the aspect that differentiates limited and unlimited regulation over retirement investments. The study also integrates dummy variable showing that individuals are limited in terms of using their contributions of contribution from governments or employers. In many instance, this is common in profit-sharing and firm stock acquirement plans, whereby contributions from employers or governments are limited in firm stock and workers’ contribution in some circumstances.

When HRS was introduced it has a total of 2277 non-retired people with at least one retirement plan, of these 20.9% individuals indicated that they used DC plans.

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Analysis

The researcher used individuals with DC plans as well as those who provided their views to investment issues, which decreases the sample size to 476 individuals.  Table 1 demonstrates a summary of individuals with DC plans, sub-sample of individuals with positive contributions to personal counts and people with zero contributions accordingly.

On average, these individuals contribute approximately 5.99% of their pay o DC plans, therefore, they contribute roughly 1.84 thousand and how they address their assets in retirement, it is accessible to 60% of individuals and about 16% of them have stock acquirement alternative or profit-sharing, implicitly workers have do  not have power over employers’ contribution to retirement plan. There were about 47% women while 80% of the sample sizes were married. Furthermore, approximately 27% of the individuals have direct benefit plans and also DC plans.

In comparison to the subsample of individuals in this study who had 0 contribution, subsample with a positive demonstrated the capacity to control their savings, manage the retirement investments and how they address their assets in retirement decision, in other words roughly 71% of the subsample have the ability to make decisions about the retirement plans while 28% have such ability in the sub-sample with 0 contribution.

All individual who had access to positive contributions were less limited in the firm stocks, thus, they had additional income with less contribution from employers that is described based on the ratio contribution from employer  to the worker’s pay.

Figure 1 demonstrates the distribution of levels of contribution in defined contribution plans and decision to invest and with no decision individually. In fact, individuals with the capacity to direct investment make more savings, manage the retirement investments and how they address their assets in retirement in DC plans, than those with no decisions to save or manage their retirement investment. However, there is a significant reduction among individuals that contribute 0 amounts and a considerable rise in those that save more than 15 % of their wages. The graph below shows that investment decision encourages the amount to save in defined contribution plans.

Results

This part provides results about how workers make decisions to save, manage the retirement investments and how they address their assets in retirement influence their level of contribution in defined contribution plans. There were about 476 individuals in the DC with roughly 22 different plans with 498 observations. Average contribution is 5.99% of their pay and standard deviation of 7.82. The mean of individual’s contribution is 8.9 while 123 individuals indicated 0 contributions.

According to the basic regression, there is asset decisions financial information, and demographic characteristics of participants. The contribution of employer in the defined contribution plans is demonstrated in Column 2, and column 3 shows other plans. Investment coefficient is not only positive but also significant, demonstrating that individuals with ability to select an investment and not limited by the design of retirement plan contribute about 3.25% more of their pay in DC plan compared to other respondents.

On the other hand, the coefficient is limited decisions is negative as well as significant, providing 3.53% less of workers contribution limited by firm stock of workers as well as employer’s contribution, indicating that individuals would not invest in the retirement plans  if they do not completely  self-direct their retirement plans.

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For instance, if contribution from employer is made in firm stock in defined contribution plans, such a system encourages workers to maintain risky portfolios. For that reason, workers with complete authority over their contributions, have to alternatives to balance such risks. On one hand is investing in less risky assets in the defined contribution plans and on the other hand is going for other risky retirement plans like direct benefit. Nevertheless, for workers with partial or no power over their contribution, the effective strategy is reducing DC plan contribution while selecting risk free retirement plans.

Interestingly, to speculate the technique of an individual decision convinces respondents to pay more to their retirement plans. People have conflicting expectations. Variation in retirement plans can tip internal balance while increasing the amount of saving. Such estimates demonstrate that with an investment decision increase salary percentage as such, the effect of employer rate- the initial rate of contribution.

It can be assumed that selecting some or even all investment decisions makes individuals to maximize the contribution level, because asset decisions partially determine the return. This contrasts passive behaviors in retirement plans, particularly, where employers are in charge of managing investment. This formulation suggests that influence of asset similar across genders. With a gender variation, significant impact of asset decision for men is about 4.01 and 0.76 as the standard error while the impact for female is 1.89 and 1.11 standard error, though not correlated to 95% confidence interval.

This shows that women investment decision is determined by investment choices to save in defined contribution plans and they are careful in risky ventures. This is guided by two reasons, for instance women have higher expectations to save maybe they have a longer life expectancy compared to men. Additionally, decision unit is household and in most scenarios women secondary income earners and their revenue supplement their spouses. In such conditions, women reported revenues are considerably lower compared to household revenue and their behavior demonstrates their level of household earnings.

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Conclusion

The paper has discussed behavior adopted by the individuals while making economic decisions and the reaction of the market towards these decisions. there are different extension that emerge. Firstly, individuals with DC plans cannot adequately control the exact amount of contribution from their salaries. Second the study offers econometric impact of investment decision , however, it does not examine the  decision variable will be a constraint on the budget of the individuals.

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