Derivatives: Forwards vs Futures

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  Before understanding what is derivative, let’s learn what is underlying asset. Underlying asset: Underlying asset can be real asset such as commodities, gold etc or financial assets such as index, interest rates etc. Derivatives: ·         These are financial instruments who value depend upon or is derived from some underlying asset. ·         A derivative does not have its own physical existence, it emerges out of contract between the buyer and seller of derivative instrument. ·         Its value depends upon the value of underlying asset. Hence returns from derivative instruments are linked to returns from underlying assets. ·         The most common underlying assets are stocks, bonds, commodities, market indices and currencies. ·         Derivatives are mainly used to control risks. They can be used to reduce risks (a process known as hedging) or to increase risks in order to enhance returns (speculation)   Classification of Derivatives: ·         Broadly we c

Defined Benefit vs Defined Contribution

Let's discuss DB and DC in a very easy layman terms

Background:

  • Pension schemes provide benefits to their employees so that they can retain the good quality staff or it might be a compulsion from government to provide pension or any other benefits. 
  • Majorly there are two types of schemes known as DB and DC
DB = Defined Benefit

  1. A defined benefit pension plan is a type of pension plan where the benefits are fixed and by benefits fixed we mean that the formula for calculating benefits is fixed. 
  2. Here the employer promises a specified pension payment or Lumpsum upon retirement, that is determined by an actuary appointed by the scheme based on the employees earnings history, tenure of service and age. 
  3. Every year employer has to contribute to the pension pot (i.e. contribution). There are various formulas structure which varies from employer to employer, some of them are as follows:
  • Final Salary: Annual benefit will be: 2%*(Final 3-year average annual salary) *Years of service. 
  • Career Average Benefit: Annual benefit will be: 1.5%*(Total Career earnings or average of participant’s career earnings). 
  • Unit Benefit: Annual Benefit will be: 350*Years of service. Do not learn the numbers, but learn the format.

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DC = Defined Contribution 

  1. Unlike a Defined Benefit plan, here the contribution amount is fixed. A pension pot is built up using the employer and employee contributions. Unlike a Defined Benefit scheme, the end benefit is not known in advance, but the monthly contribution to be made from both parties can be determined. 
  2. Here the contributions into the fund will be increased by investment returns earned over the period of time.
  3. It also has some types such as 401k plans in US but let's not get into that much detail.


As an Actuarial Consultant, what can you suggest to your client? Let’s see 2 different Cases

Q.) If client has issues of Labour Turnover and now they want to offer attractive benefits So, what should they do?

A.) They should go for Defined Benefit Plans as employees are encouraged to stay for longer period as benefit grows exponentially as the tenure with the company increases

Q.) If client starts his high-tech business and he wants to provide benefits to employees which can be portable (i.e. Transferrable) to another employer as well and can hire employees at any age, what should they do?

A.) They should go for DC plan here, as they can attract even a college graduate who is looking for employment. It allows employees to have an option of transferring their account balance to another employer. Even the mobile workforce valued the DC plan due to its portability.

 

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