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Defined Benefit Pension Scheme
A pension scheme that provides a guaranteed benefit is commonly called a defined benefit pension scheme.
A defined benefit scheme typically employs a formula based on the employee's pay, years of employment and age at retirement to calculate the guaranteed payment.
When we talk about a 'benefit' we are generally talking about pensions. A benefit is really just another way of describing either of a pension or cash amount or some other sort of reward. For example free dental care at work might be described as a 'dental benefit'. On similar lines a pension might be described as a 'retirement benefit'.
A Defined Benefit (DB) Scheme is exactly that, a pension scheme where the benefit (i.e. the pension in most cases) is 'defined' in some way. Therefore it may be helpful to think of this as a "Defined Pension" Scheme. One quite popular kind of defined benefit scheme is known as a Final Salary scheme. In this sort of scheme a member may be promised a pension of say 1/60th of salary at retirement for each year of service. The pension promised is in no way related to the amount of money put in. In a defined benefit scheme the focus is on the pension not on the contributions paid.
Defined Contribution Pension Scheme
A Defined Contribution (DC) Scheme (also sometimes described as a Money Purchase Scheme) is in some ways the complete opposite of a Defined Benefit Scheme. In a DC Scheme the amount of money paid into the pension scheme is the focus e.g. the employer may promise to pay 5% of the salary into the scheme each year. These amounts are then invested to produce a fund at retirement. However the pension available at retirement will depend upon the level of contributions paid, investment returns earned and the cost of purchasing pension at retirement. These things cannot be known in advance and hence the pension it produces cannot be known also. The pension (or benefit) is not defined it is the contributions which are defined. The starkest difference between a DC and a DB scheme relates to which party (company or member) bears the risk.
In a DB Scheme the benefit is promised and the company takes the risk of meeting the eventual cost of this, the cost cannot be known in advance and so could be more than the company had estimated.
In a DC Scheme the company pays a set amount into the fund. The payments that will be made will depend on the investment performance of the assets in which the pension funds are invested. Typically the funds are invested in mutual funds, government securities, bonds and so on. Thus in a defined contribution plan, the employee bears all the investment risk. After retirement, the individuals can draw income from the fund.
The Pension system in India
NEED OF PENSION PLAN IN INDIA
In India, while the total population is expected to rise by 49% between 1991 and 2016, the number of elderly (persons aged 60 and above) is expected to increase by 107%, to 113.0 million. In other words, the share of the aged in the total population will rise to 8.9% in 2016. Demographic projections further suggest that the number of the aged will rise even more rapidly to 179 million by 2026 -- or to 13.3% of the population.
Males and females in India at age 60 today are expected to live beyond 75 years of age. Thus, on an average, an Indian worker must have adequate resources to support himself or herself for approximately 15 years after retirement. Demographic projections suggest that a 40-year-old today, who will be 60 in 2020, will have an expected life span of 20 years beyond 60, i.e. to age 80.
While we witness an increase in the number of aged, the traditional and informal methods for income security, such as the joint family system in India, are increasingly unable to cope with the enhanced life span and medical costs during old age. There is a growing stress on the joint family system and there is an immediate need for introduction of formal, contributory pension arrangements that can supplement informal systems. This problem is particularly important in India, which will enter its demographic transition, into increasing number of aged persons, at lower income levels than those seen in other countries which have long introduced systems to cope with the problems of an ageing population.
There is a serious threat that a majority of these workers, who may not be below the poverty line in their working lives, might sink below the poverty line in their old age, simply because they have not accumulated enough savings during their years in the workforce. This problem is further compounded since they will have to incur heavier expenditure on health during old age, neglect of which would only worsen their quality of life.
Demographic transition coupled with poor coverage by existing provisions suggests that we are inexorably moving towards an India with a gigantic number of destitute elderly. Faced with such huge numbers, a social safety net for retired workers or a poverty alleviation program which aims to pay even a modest subsidy would require a staggering expenditure -- much beyond the capacity of the Government.
Recommendations:
A new pension system
An individual should maintain an account; have a passbook where he can see a balance that is his notional wealth at that point in time; he should control how this wealth is managed; this account should stay with him regardless of where he is or how he works. He would make contributions towards his pension into this account through his working life (whether employed in the organised sector or not), and obtain benefits from it after retirement for the rest of his life. A heuristic sketch of the operations of this system may be offered here.
The individual should save and accumulate assets into his account in his working life, subject to a minimum of Rs 1000 per contribution and Rs 500 in total accretions per year. Individuals would be free to decide the frequency of accretions into their accounts; there will be no pressure to make a fixed monthly contribution. Finally, upon retirement, the individual would be able to use his pension assets to buy annuities from annuity providers, and obtain a monthly pension.
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