Do our pension plans carry risk?

This is a monthly column in Economic Times by Priya Sunder, Director and Co-founder of PeakAlpha.

Understanding Pension Risks Through Real-World Examples

In 2013, the Saradha Group financial scam threatened to bring down the ruling government in West Bengal. The group ran fraudulent investment sch emes, collecting thousands of crores from lakhs of investors, promising astronomical 50% returns. However, it did not use investors’ money to build assets, but took it from new investors to pay the older ones. It was a classic example of a Ponzi scheme.

It is ironical that while governments try to stem such fraudulent investment structures, they themselves perpetrate these schemes. In 2014, the US Congress announced severe cuts in the pension benefits of one million employees covered under the Pension Benefit Guaranty Corp (PBGC). PBCG is a government agency that protects the pensions of almost 1.3 million people covered by more than 200 pension plans. The largest cuts are proposed for the younger employees, and the smallest for the older ones. Newer employees are forced to fund the deficit in investment earnings to pay older pensioners.

Aren’t there uncanny similarities between Saradha and the PBGC? Both were moneypooling schemes that needed a constant flow of new money to keep their operations afloat. The schemes kept growing until payouts to existing members exceeded the cash inflow. Both are in a state of collapse because of over-commitment and under-delivery.

What Are Defined Benefit Pension Plans?

Do pension plans in our country bear the same risk as in the US? There are two kinds of pension schemes—defined benefit and defined contribution. Under defined benefit, the employer or sponsor promises to pay a specific amount to the employee as pension during his retirement years. This amount is predetermined and based on parameters such as annual contribution during working years, years of service, life expectancy and investment returns. Using actuarial calculations, the sustainability of the payout is determined. The pensions of most government employees and army personnel in India are defined benefit programmes.

In a defined contribution plan, the employer and the employee make regular contributionsto the fund. There is a promise to contribute a fixed amount, usually a percentage of the employee’s income, during his working years. There is no obligation to pay a fixed amount during retirement. The employee can choose the investment vehicle and the amount he accrues depends on his and the employer’s contribution to the fund and the term of growth. Members are entitled to benefits in proportion to what they have contributed. This is a more sustainable and equitable way of building a pension fund. The National Pension Scheme in India is an example.

Why Defined Benefit Pension Plans Can Carry Risk

The defined benefit plans are a cause for concern. When there is a change in the economic growth, investment returns or demographic expectations on which the benefit payouts are based, the quantum of payout is threatened. So, if the return on corpus fall due to slow economic growth or if the payout tenure increases because of a rise in pensioner life expectancy, the stream of periodic payments or projected returns may not be viable, resulting in benefit cuts. Should we be concerned about the defined benefit payouts are based, the quantum of payout is threatened. So, if the return on corpus fall due to slow economic growth or if the payout tenure increases because of a rise in pensioner life expectancy, the stream of periodic payments or projected returns may not be viable, resulting in benefit cuts.

Are Pension Plans in India at Risk?

Should we be concerned about the defined benefit plan in India? I don’t think so. These tend to fail in countries with ageing populations. India has a young population, an advantage over developed countries. The number of people in the working age group surpasses that of retirees. This demographic dividend will ensure that even defined benefit plans protect the retirees’ income for some years to come.

The author is Director, PeakAlpha Investment Services

A thoughtful retirement plan can make a big difference to your financial future. Advisors at PeakAlpha work with individuals and families to help them make informed decisions about investments, pensions, and long-term financial goals.

The author is Director, PeakAlpha Investment Services

FAQs

1. Are pension plans completely risk-free?

Pension plans are generally designed for long-term retirement security, but they are not entirely risk-free. Factors such as investment performance, economic conditions, and demographic changes like longer life expectancy can affect pension sustainability.

2. What is the difference between defined benefits and defined contribution pension plans?

Defined benefit plans promise a fixed retirement payout based on salary and years of service, while defined contribution plans depend on the contributions made and the investment returns generated over time.

3. Who bears the risk in pension plans?

In defined benefit plans, the employer or pension sponsor typically bears the investment and funding risk. In defined contribution plans, the employee bears the investment risk because retirement benefits depend on market performance.

4. Can pension plans fail or reduce benefits?

Yes, pension plans can face challenges if investment returns fall, funding becomes insufficient, or demographic factors such as longer life expectancy increase the cost of payouts. Poor management or underfunding can also reduce benefits.

5. Are pension plans in India safer than in ageing economies?

Countries with younger populations often have stronger pension sustainability because a larger working population supports retirees. This demographic advantage can help maintain pension systems for longer periods.