Disadvantages of Defined Contribution Pension Plans

Defined contribution plans have come under a lot of criticism because of the various disadvantages that they have. Many of these plans have been viewed as a covert way to absolve the government of any responsibility related to the retirement of its citizens.

Given the many other socio-economic factors which are at play, defined contribution plans are viewed as having replaced the assurance of a pension plan with the uncertain vagaries of the market.

In the previous article, we have seen how the world has moved from defined benefit pension plans to defined contribution pension plans. We have also seen why private entities all across the globe have been supportive of this change. Their willingness to quickly implement this change has led to a situation wherein more than three-quarters of pensions in the world are based on defined contribution plans.

There are serious drawbacks to defined contribution plans. Such drawbacks warrant a detailed discussion. In this article, we will discuss some of the common disadvantages which are associated with defined contribution pension plans.

1. Linked to Financial Markets: The biggest downside of a defined contribution pension plan is that the concept of fixed benefits has become obsolete since the introduction of such plans.

   A defined contribution pension plan works by passing on the market risk to the employee. Hence, the company is merely a trustee which contributes a given sum of money to the markets on behalf of the employee. The employee bears complete responsibility for market risks. Hence, if the retirement corpus of the employee becomes very low because of market conditions, then the company is not liable to pay the difference. On the flip side, if the employee is able to generate phenomenal returns in the market, they are entitled to keep those returns too.

   The problem with this arrangement is that financial markets can be quite risky. Since people who retire do not have any other sources of income, many experts consider their exposure to financial markets as being excessively risky.

2. High Fees: A defined contribution pension plan can be thought of as a type of mutual fund. A lot of investors pool their money which is locked in over long periods of time. Just like mutual funds, pension funds also have fund management expenses.

   In many cases, pension funds tend to be inefficient. Hence, their expenses tend to be higher than average mutual fund. Since pension investments are held over very long periods of time, the difference of a few percentage points can make a huge difference to the corpus.

3. Higher Unemployment: The problem with defined contribution pension plans is that employees have to first make large contributions to the fund in order to be able to compound that money over large periods of time. However, in many places across the world, there is large-scale unemployment. This is truer in the case of older employees.

   There are many industries such as the tech industry where there is an implicit preference for having a younger employee on board. If not outright unemployment, underemployment is also common in many industries. Due to high unemployment people have to take jobs which they are overqualified for.

   If a large number of people are unemployed or underemployed, their pension contributions tend to be inadequate. This is very different from defined benefit pension plans where stable employment was a given.

4. Lower Growth of Income: The final corpus value of a defined contribution pension plan is dependent upon the employee’s recurrent contributions. At the same time, the employee’s contributions are themselves dependent upon the growth rate of their business. However, over the past few years, employee wages have been largely stagnant. On the other hand, their expenses have been steadily rising due to inflation.

   In other words, the real income of the employees tends to do go down with time.

   Over time, this translates to a smaller percentage of the salary being channeled towards defined contribution pension plans. Smaller monetary inputs in the scheme finally lead to a situation wherein the final corpus is also smaller than required.

5. Longevity Risk: A defined contribution pension plan provides users with the option of taking either lump sum payments or periodic payments. The periodic payments also tend to be a fixed amount. These amounts generally do not increase on a yearly basis. However, with the advances in medical science, the average life expectancy of human beings has increased significantly.

   Hence, defined contribution plans always bear the risk that the employee may live to an age where they either run out of their corpus money or the money that they receive on a monthly basis has very little value thanks to high inflation rates.

   It is also important to note that the cost of medical treatment has been spiralling out of control over the years. Also since medical expenses are a big part of the overall expense of the retirees, the inflation rate for retirees tends to be much higher than the average inflation rate.

   Hence, the pension amount which may seem significant in the early years of retirement may quickly become insufficient in the later years.

The bottom line is that defined contribution pension plans have some serious disadvantages if the employee is not disciplined with their contributions. Also, the onus of risk-taking and choosing the asset class falls on the employee who may not be able to make the best decisions.

Companies are happy to implement defined contribution pension plans since they only have to act as a trustee. They are not liable to pay a fixed amount to the employee regardless of market conditions.