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Corporate Financial Management Of Superannuation

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Questions:

1.What are the important factors that should be considered by tertiary sector employees when they are deciding whether to place their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan? What issues relating to the concept of the time value of money may be important in this decision-making process?

2.If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin,Explain why this is not the case?
 
 

Answers:

1. There are two investment options with regards to superannuation for the tertiary employees which have been outlined in the given question. A brief discussion of these two would be helpful in carrying out further discussion on the topic and address the key issues at hand.

Defined Benefit Plan

As the name suggests, this is a type of plan where the annual returns are defined and hence there is no fluctuation of the annual returns on the performance of the underlying portfolio investment from the pooled superannuation fund. The contribution to the superannuation plan is pooled and invested across a host of asset as thought appropriate by the trustees and any potential gains and losses are borne by the trustees only while ensuring that the employees are safe and would be assured of a pre-determined rate. As a result, in this, the concerned employee can plan as to how much money should be invested periodically so as to assure that at the retirement time, the concerned individual has a particular amount which the person desires to meet expenses post retirement.

 

Investment Choice Plan

In contrast to the defined benefit plan, the investment choice plan does not offer any fixed returns and these essentially would depend on the performance of the market and the various assets in which the investment is made. As the risk appetite of various employees tend to be different depending upon a host of factors, hence various choices are given in terms of the funds and the composition of the same. For instance, a secure fund would limit investment only to the debt instruments and then gradually incremental funds would tend to increase the percentage weight of equity representation to reach an all share fund which would typically have the higher risk but with the potential of higher returns as well. In this particular plan, annually the gains made can be shared amongst the members after making the requisite deduction for management fees and other expenses.

Having discussed the broad contours of the two available plans, the various factors that the tertiary sector employees would consider while availing a particular plan are highlighted below.

  • Amount of risk averseness

There are some employees who would prefer the fixed benefit plan over the investment choice plan only because it offers a fixed return which is not market linked. Most people especially those who do not have exposure to stocks or other financial assets tend to be skeptical of the fluctuations in the market. Additionally, since some investors do not want to assume risk, hence a lower but assured returns sound more lucrative to these instead of the potentially higher average returns that could be offered through the investment choice plan (Ross, Trayler and Bird, 2007).

  • Savings level of employees

For employees having low savings, it is preferable to opt for defined benefit plan. This is because these individuals might only have the superannuation fund as the only option for the post retirement expenses as other savings would be meager only. In such a scenario, the concerned person is driven by capital preservation rather than capital appreciation and therefore would be driven by the promise of defined and assured benefits (Damodaran, 2010). On the other hand, an employee who has high savings can afford that the returns are lower or there is some loss of capital as there are alternate support mechanisms for the post retirement life and thereby higher flexibility to assume risk is available and therefore such individuals may be more declined at being comparatively more risk taking and hence preferring the investment choice plan (Brealey, Myers and Allen, 2012).

 

  • Amount of funds required at retirement

It is obvious that the returns offered under the defined benefit plan would be lesser in comparison to the highest possible return in the investment choice plan. This is primarily because of the underlying market risk that is involved in the later scheme and since the investor is willing to assume risk, hence he/she would be deserve higher risks also (Damodaran, 2007). Considering the rate offered, age at which contribution to the superannuation starts, it might be impossible for the investor or employee to reach the intended target by the time of retirement. It therefore would make sense for the employees to search for alternatives primarily in the form of investment choice plan whereby assuming higher risk, the concerned individual can potentially reach the intended goal (Beck et. al., 2013).

  • Familiarity with stock market

There are some employees those who do not know much about the stock market but are aware that it can potentially yield superior returns. Since they lack the innate understanding, hence they prefer passive investment in comparison to active investment. Hence, it is likely that these may prefer the investment choice plan which provides the investor with an opportunity to enter the market with a risk level that they intend to take. For a risk averse employee also, there is the irrational fear associated with the market vagaries and preference for the defined benefit plan so as to avoid any speculation (Bodie, Merton & Cleeton, 2009).

  • Current Investment & Portfolio

It is quite possible that some of the employees may be active investors and thus may have portfolios of their own. Such investors may look at hedging their portfolios by investing in defined benefit plan so that even if there is a market crash and they tend to incur heavy losses on their portfolios atleast they have their retirement funds secure and thus would not have to worry. On the other hand, investors with no exposure to asset markets may be more willing to take exposure through investment choice plan (Brealey, Myers and Allen, 2012).

  • Liabilities on employee (Both Present and Future)

The choice made by the employee in relation to the superannuation plans would also depend on the current and future liabilities on the concerned person coupled with the age. At a young age, the liabilities are typically lesser and also earnings have just commenced and hence the focus is on capital appreciation with a bias towards the investment choice plan. However, as age passes by, liabilities increase and also the focus shifts to capital preservation as retirement seems approaching. Thus, depending on the priority, age and underlying liability, the employee decision would change (Ross, Trayler and Bird, 2007).

 

Role of time value of money

In reaching a decision with regards to the suitable plan, it is pivotal the take the time value of money into consideration. This is because money has an opportunity cost attached and therefore it is imperative that the plan chosen should be such that it should provide superior returns for the investor. It is imperative to note that return must not be looked at in isolation but rather in association with underlying risk and investor should take decisions which tend to maximize the return per unit risk (Damodaran, 2007).

For instance, while comparing the two plans, it is imperative to consider the opportunity cost of the money and thereby evaluate the available options. Thus, the returns given by the various plans should not be evaluated using absolute numbers but the relative approach is more preferable. For instance, if a defined benefit plan offers an annual return of 2% pa while the investment choice plan could offer 8% by choosing twice as risky an asset allocation. Further, assume that the money could be deposited in the bank with an assured return of 2.5% p.a. In such circumstances, it does not make sense to invest in defined benefit plan due to abysmally low returns while the return per unit is impressive for investment choice plan which should be preferred (Troughton et. al., 2012).

Also, it is imperative to note that with time the money tends to lose value on account of inflation and this should also be considered. This is especially useful in deciding a target that the concerned individual would intend to have at retirement so as to have an annuity which could maintain the expenses. The same expenses as total could potentially cost several times after retirement depending upon how far is the retirement time from the present time (Brealey, Myers and Allen, 2012). But assuming an average rate of inflation, suitable adjustments have to be made so as to narrow down a particular annuity payment desired so that the future value of corpus at the time of investment may be determined. Based on these computations coupled with the available contribution that can be made periodically, the desired rate may be computed and then it can be evaluated as to which particular investment plan could potentially offer that return. If the defined plan can meet the desired target in accordance with the time value of money, then the same should be preferred or else investment choice plan may be the best bet (Damodaran, 2010).

 


2.
It is imperative to understand the EMH or Efficient Market Hypothesis before making an attempt to answer the question. The broad outline of the EMH is that the financial markets are efficient and therefore no investor can sustainably and consistently beat the market by indulging in any type of analysis be it technical, fundamental analysis or any other technique. There are three different levels of efficiency which a stock market may exhibit (Ross, Trayler and Bird, 2007). These are briefly outlined below.

  • Weak form EMH

In accordance with this, the future stock prices tend to follow a random walk and are not related to past prices in any manner. As a result, technical analysis is futile as through empirical data it searches for price patterns and then prescribe trading calls based on these underlying price patterns (Damodaran, 2007).

  • Semi-strong form EMH

In accordance with this, whenever any new material information is available which tends to impact the valuation of the stock, the stock price adjusts in such a manner that it does not offer any potential to the investors to earn abnormal returns. As a result, it hints towards the futility of fundamental analyses which aims at particular news flow for estimating the movements in the stock prices and also assuming positions (Berk et.al., 2013).

  • Strong form EMH

In accordance with this, all the information irrespective of whether it is public or private is already built into the stock price at which it trades in the market and the market price tends to be the intrinsic price and does not offer arbitrage opportunities which would allow the traders to make abnormal gains and beat the market index (Damodaran, 2010).

The above discussion may reflect that the pension fund manager has no role to play in a efficient market since tools like technical and fundamental analysis are futile as the prices follow a random walk and also no trading opportunities are provided whenever a new information enters. Also, the current stock price may be reflective of the intrinsic price. However, despite this, the fund manager cannot pick the stocks with a pin and has a pivotal role to play as explained below (Troughton et.al., 2012).

The stock market offers two kinds of risk i.e. diversifiable risk and non-diversifiable risk. The diversifiable risk cannot be avoided no matter what the fund manager might do. But it is imperative that diversifiable risk also called unsystematic risk should be minimized through diversification. As a result, it is imperative that the fund manager does not choose the stocks randomly as it may not lead to a well diversified portfolio and hence the overall risk would be higher (Bodie, Merton & Cleeton. 2009). Further, considering that the manager is looking after pension fund, thus typically those stocks must be chosen which have typically lower beta and are therefore not very risky.  This cannot be carried out in a random manner as the resultant stock may be highly risky and unsuitable for pension fund investment. Also, the fund manager should aim to invest in stocks which have the higher return per unit risk in accordance with the portfolio theory. As a result, it may be concluded that the pension fund manager must not choose stocks with a pin even in a efficient market (Brealey, Myers and Allen, 2012).

 

References

Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2013) Fundamentals of corporate finance. 2nd edn, London: Pearson Higher Education

Brealey, R.A., Myers, S.C. and Allen, F. (2012) Principles of corporate finance. 2nd edn. New York: McGraw-Hill Inc.,US.

Ross, S.A., Trayler, R. and Bird, R. (2007) Essentials of corporate finance. 2nd edn Sydney, Australia: McGraw-Hill Australia.

Damodaran, A. (2010) Applied corporate finance: A user’s manual. 3rd edn. New York: Wiley, John & Sons.

Damodaran, A. (2007) Corporate finance: Theory and practice. 2nd edn. New Delhi: Wiley indiaPvt.

Troughton, G.H., Fridson, M.S., Scanlan, M. and Clayman, M.R. (2012) Corporate finance: A practical approach. 2nd edn. United States: John Wiley & Sons.

Bodie, Z., Merton, R. C., & Cleeton, D. L. (2009). Financial management, 2nd edn. New Delhi: Pearson Education India.

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