The ABC of pensions (Part 1)

In recent years there has been much debate about the sustainability of public pension programs. To begin to resolve the challenge, we must start by understanding what they are and how they work.

A pension plan is a scheme whereby individuals, during their productive life, periodically contribute part of their salaries or income to a pension savings account. The accounts can be individual or collective. The money accumulated there, plus the returns on the investments produced by such savings, form the capital. At retirement age, contributors will derive an income for their old age. 

Thus, the pensions that contributors derive from their plans depend on how many years, amounts and investment returns they contribute during the life of the savings. Any benefit in excess of the financial result of these variables is always the result of some cross-subsidy or payments from third parties, such as the government, to improve pensions. And this brings us to a central issue, the criteria for distributing pension benefits. 

Pension benefits

There are two types of funds, Defined Benefit (DB) and Defined Contribution (DC). Defined Contribution plans are those in which you know what you put in; but what you receive at the end will be determined by those payments, the time you make them and by the return on investments. You know what you put in, but you do not know beforehand what you will receive. There, the fund has no external risk since it only pays out what the fund generated. Normally these funds are composed of individual accounts for each of its participants and where each one can see what he/she has put in and what he/she has received. Just like a bank account, but where the money is not available until it is withdrawn.

The other system is the Defined Benefit (DB). In the DB, the contributor knows in advance how much he/she is going to take at the end of his/her productive life -as long as he/she meets the requirements of age, number and amount of contributions. This amount is usually expressed as a percentage of a formula based on your salary history. Here, investment market returns are ignored.