Risks Associated with Choosing a Superannuation Fund of financial

Question: What Is The Risks Associated With Choosing A Superannuation Fund? Answer: Introducation: Superannuation and encouraging people to consider saving and investing especially for their future after retirement have been a major focus of emphasis in Australia particularly in the past two or so decades(Bodie, Shoven, Wise, 1988). Superannuation refers to organizational pension schemes that are created within a company for the maximum benefit of the employees. Taking the lead in this has been the Australian government that has taken a pro-active approach to the issue and directed that minimum contributions should be made to demonstrate compliance to superannuation or retirement funds on behalf of the employees by their respective employers. This figure stood at 3.6% of the employees salary when it was introduced but it was later amended to 9% in 2005(Bodie, Shoven, Wise, 1988). The employees themselves were also required to allocate a share of their income to superannuation investment. It was hoped that by introducing these measures, the burden will be lifted from the social s ecurity system that provides retirement or pension payments to support retired individuals for the rest of their lives after retirement. The mandated requirements on superannuation and increased awareness by individuals on the significance of saving have resulted in billions of dollars worth of contributions going into superannuation funds and institutions of finance each year(Brown, Gallery, Gallery, 2002). The financial institutions and the superannuation funds in turn participate in profitable investment of these contributions and provide adequate income to finance the lives of the individuals after they retire. It is therefore, no surprise that superannuation and mutual funds are considered as one of the biggest investors in the financial markets in Australia especially in equity securities in both locally listed and internationally listed companies in the share markets(Bodie, Shoven, Wise, 1988). There are varied employer pension programs in terms of design and can be classified as define contribution and defined benefit programs. The defined contribution program allows an employee to have an account into which their employer will deposit regular contributions(Bodie, Shoven, Wise, 1988). If the account is a contributory account, the employee also makes regular contributions. The level of benefits that the employee will receive depend on the total contributions and earnings from investments that will have accumulated in the account. In this plan, the employee has a considerable say in the type of investment assets that the accumulation can be derived from and can also determine the value of investment at any time suitable to them. The defined contribution plan are thus tax-deferred and fully funded savings accounts in trust for an employee. These plans are effectively not open to government regulators(Bodie, Shoven, Wise, 1988). A defined benefit plan on the other hand, a formula is used to determine an employees pension benefit. The formula takes into account the years of service to an employer, their wages, and salaries(Dulebohn, Murray, Sun, 2000). Several of the defined benefits programs in existence today take into account the benefits of social security entitled to the employee. Both the defined benefit and defined contribution plans have characteristic features that set them apart from each other with regard to the risks that apply to the employee and the employers, the impact of inflation to the benefit, the flexibility of funding, and significance of governmental supervision(Dulebohn, Murray, Sun, 2000). In recent times, there has been a steady shift from defined benefit pension plans to accumulation plans in Australia(Princen, 2013). More than half of this change is attributable to the changes in employment arrangements from large unionized manufacturing firms to smaller firms that are not unionized in the service industries that provide accumulation plans. This shift is attributed to an increase in the administrative and regulatory costs that have made defined benefit plans more expensive to employers due to the heightened regulatory scrutiny(Dulebohn, Murray, Sun, 2000). High labour mobility also made the prospect of defined benefits programs less attractive to employees. Superannuation in Australia has grown to about 90% since its inception but the majority of funds that are being established are accumulation funds and not defined benefit plans(Dulebohn, Murray, Sun, 2000). Fewer employers are offering their staff superannuation based on defined benefit programs. Consequently, the number of defined benefit plans has reduced significantly or are simply not available to new employees in the organizations and instead these individuals are advised to enroll to accumulation plans. In an accumulation plan, an employer pays an agreed amount, usually a percentage of the employees current salary to the superannuation fund(Brown, Gallery, Gallery, 2002). The employers obligation to the employee is fully discharged once their contribution has been deposited into the superannuation fund. The employees benefit from that moment on depend on the accumulation of their contribution to the plan including their earnings. This is different from the defined benefit pac kage where an actuary regularly reviews the rate of contribution and the extent to which assets contained in the superannuation fund are sufficient to cover obligation of paying benefits(Brown, Gallery, Gallery, 2002). If the actuary determines that the assets are inadequate to do so, the employer is under obligation to make additional contributions to the fund to cover the deficit(Brealey Meyers, 2010). In a defined benefit program, the employer covers the risk that the plan will cost more than the expected amount alongside the risk that the investment plan will generate less returns as compared to the expected(Chew, 2008). This stems from the increased administrative and investment costs that are incurred in management of the fund. For this reason, most employers underwrite the plan. On the other hand, in the investment choice plan, the employer is not obligated to the plan after making their periodic contribution to it. Thus, the employees or members of the fund bear the actuarial and investment risk associated with the fund particularly with its administration or management(Dulebohn, Murray, Sun, 2000). The members in this arrangement have a range of investments to choose from and these investments expose them to varying degrees of risk(Dunphy, Benn, Griffiths, 2014). The merits of a DBP and an ICP plan are balanced. Looking at future expected returns, both plans offer similar expectations in common circumstances thus it cannot be said that one plan is the better option of the two. In terms of benefits, the differences arise due to factors such as the age of the member, years of membership and future increments of their salary. Differences between the two plans in terms of the benefits that are ultimately payable arise from individual factors such as the members age, years of SSAU membership and future salary increases. Stevens assessment suggests that there was no bias at the time of the offer in respect of the two types of benefits that might have induced members to select one plan over the other. Risks Associated with Choosing a Superannuation Fund To achieve the objective of maximizing an individuals retirement benefits relies heavily on making an informed choice. An individuals unwillingness or inability to be informed and the costs involved in acquiring information play a significant role in making a choice, often an informed one(Dunphy, Benn, Griffiths, 2014). Evidently being informed includes taking time to acquire, review, and interpret the reports and other investment material. It also includes attending training sessions, consulting professionals on financial matters among other forms of information. Making the wrong decision can be costly. When the costs significantly exceed the perceived benefits of the choice, then a person can avoid the program altogether(Bolton, 2015). The risk transfer costs is a factor that needs to be considered irrespective of the amount or intensity of education an individual can receive. These costs include the costs of becoming informed as aforementioned such as the time invested into the exercise, or consultation with a financial expert, and never-ending process of monitoring the ICP option(Dulebohn, Murray, Sun, 2000). These factors have made many individuals to remain in the defined benefits program and not switch to the investment choice plan. The manner in which the benefits under each plan are determined is another area to consider before making the switch. Under the DBP, the employees benefit in the plan is linked to their period of employment and the final salary they receive before retirement. An Investment Choice Plan is similar to a savings account in a bank in that ultimate benefit is a sum of the accumulated contributions and the net investment earnings from the point that the periodic contributions are made(Quiry, Fur, Salvi, Dallocchio, Vernimmen, 2011). Thus, the different ways in which value is determined should be a concern to the tertiary employee. For example, a DBP is based on a formula and accrues over a long period hence; it is not possible to establish their exact value at any point in future(Bodie, Shoven, Wise, 1988). ICP benefits, in contrast, can be determined from the cumulated contributions and earnings from an established point(Bodie, Shoven, Wise, 1988). The characteristics of work and the risks brought about by the employee are also noteworthy in this case. This is because these risks contribute to the differences in the expected value of the benefits derived from both plans(Princen, 2013). Characteristics of work are inclusive of the initial age of employment, years of service, level of salary during the period of employment and retirement, and the longevity after retirement(Dulebohn, Murray, Sun, 2000). The most significant of these risks are those that come from changing jobs and risks emanating from the financial market. Both worker characteristics and types of risks borne by employees are contributory factors to differences in the expected value of benefits derived from defined benefit and accumulation plans. Worker characteristics include age at initial employment, years of service, salary levels during employment and at retirement, and longevity post-retirement. The major risks that lead to differences in the expected values of defined benefit and accumulation plans are those associated with changing jobs and financial market risks. Financial market risk is the second major risk and the most relevant to our study. In accumulation plans members directly bear financial market risk, whereas members of defined benefit plans are only indirectly exposed to such risk. In accumulation plans that offer choice of investment strategy, it is essential that members have a certain level of financial literacy to evaluate and monitor performance of the alternatives. In choosing an investment option, members are f aced with the tasks of examining, comprehending, and evaluating an array of financial information to assess the relative merits of the differing superannuation plan options. This process includes considering the nature of the investment strategy for each option, allocation of assets within each option, and assessing the relative risks and returns of each option to determine which one best matches the members risk-return preferences. Superannuation fund members who are more comfortable with making such significant investment decisions and are more willing to accept the associated financial risks are more likely to choose an accumulation plan over a defined benefit plan The statement is false because there are some factors that need to be taken into account. First, the efficient market hypothesis does not mean that the selection of the portfolio is carried out using a pin. There are still three issues that the manager needs to address. Top on that list that the manager needs to ensure that the portfolio has been diversified satisfactorily(Chew, 2008). The logic behind this is simple. A huge number of stocks is simply not enough to secure diversification. Hence, the resulting portfolio may not be well diversified if large stocks are taken as the measure for diversification. The result is that this may leave the fund with a unique risk that will not be recognized or rewarded. The manager should thus make sure that the portfolio is diversified well because the large number of stocks could all be in similar industries, a factor that does not represent many returns(Brealey Meyers, 2010). Hurling pins at the stock page may create diversification of the p ortfolio but the expected return or risk from the resultant portfolio cannot be controlled. Second, the resulting portfolio may bear excessive amounts of systematic risk for the individuals(Quiry, Fur, Salvi, Dallocchio, Vernimmen, 2011). With additional wealth it may not be too big a concern for these individuals to invest in an asset without any risks. However, if there is no additional wealth, the portfolio presents a very high beta with respect to the individuals preferences of risk. The pension fund manager will need to ensure that the risks associated with the diversified portfolio augers well with the clients. For the pension fund, the manager should select the portfolio that represents a safe investment for the client, which in this case refers to the stocks or bonds or a combined portfolio that have a lower beta(Princen, 2013). It is also prudent to consider the presence of taxes in this imperfect world. An investors tax position is very critical in a matter such as this one. Some specific assets have the tendency to generate surpluses due to their high taxability nature emanating from the equilibrating process(Princen, 2013). For investors in the lower bracket, the after-tax returns on the assets is manageable and favorable. Therefore, the manager should take the status of the tax into account in this case. Thus, the pension fund manager should tailor the portfolio in a manner that takes advantage of the special tax legislature governing pension funds(Brealey Meyers, 2010). Such legal provisions make it possible to increase the returns expected from the portfolio without incurring extra risk on the venture. References Bodie, Z., Shoven, J. B., Wise, D. A. (1988). Defined Benefit versus Defined Contribution Pension Plans: What are the Real Trade-offs? In Pensions in the U.S. Economy (pp. 139-162). Chicago: University of Chicago Press. Bolton, B. (2015). Sustainable financial management investments: Maximizing corporate profits and long-term economic value creation. New York: Palgrave, Macmillan. Brealey, R. A., Meyers, S. C. (2010). Principles of corporate finance. New York, NY: McGraw Hill. Brown, K., Gallery, G., Gallery, N. (2002). Informed superannuation choice: constraints and policy resolutions. Economic Analysis Policy, 32(1), 71-90. Chew, D. H. (2008). Corporate Risk Management. New York: Columbia University Press. Dulebohn, J., Murray, B., Sun, M. (2000). Selection among employer-sponsored pension plans: The role of individual differences. Personnel Psychology, 53, 405-432. Dunphy, D. C., Benn, S., Griffiths, A. (2014). Organizational change for corporate sustainability. Abingdon, Oxon: Routledge. Princen, S. (2013). Determining the impact of taxation on corporate financial decision-making. Reflets perpectives de la vie economique, 161-170. Quiry, P., Fur, Y. L., Salvi, A., Dallocchio, M., Vernimmen, P. (2011). Corporate finance: Theory and Practice. New York, NY: John Wiley Sons Inc.