Questiones about time value of money

One of the largest individual, industry-based superannuation funds is UniSuper Ltd, which services and manages superannuation for employees in the tertiary education sector in Australia, including universities, TAFE colleges and other higher education institutions. The other revolution in superannuation funds management and service provision in recent years has been a significant increase in the variety of superannuation fund products and investment and retirement plan options, with members now having much greater flexibility in deciding what types of funds and assets their superannuation contributions are invested in. In line with this increasing investment choice, UniSuper Ltd offers its members two forms of superannuation plans:

• a Defined Benefit Plan
• an Investment Choice Plan.

As the name suggests, the Defined Benefit Plan is one where the benefit paid to employees at retirement is determined using a formula, which factors in determinants such as employees' final average salary, age and the number of years that they have been employed. Under the Defined Benefit Plan, employees' retirement benefit is calculated as: ?retirement benefit = benefit salary ´ length of membership ´ lump-sum factor ´ average service fraction ?For tertiary education employees who elect to adopt the Defined Benefit Plan, their superannuation contributions are pooled and invested in a selection of assets determined by the UniSuper Ltd trustees. As their final benefit payout is determined solely by the above formula, the investment performance of their asset portfolio is effectively irrelevant and does not affect their final retirement payout: the investment risk is borne solely by UniSuper Ltd. This implies that employees do not benefit from gains earned by their asset portfolio (above the minimum requirement to meet their defined benefits) and it is the responsibility of the UniSuper Ltd trustees to be able to fully fund these defined benefits. The trustees of the Defined Benefit Plan do have the discretion to pay an additional accumulation benefit on an annual-adjusted basis, although this is not guaranteed and will form a small proportion of overall superannuation benefits under this plan. ?Those employees who choose the Investment Choice Plan retain an individual investment account comprising employer-sponsored and personal superannuation contributions and an annual distribution of gains earned on their invested contributions, less any administration and management charges. Under the Investment Choice Plan, employees can nominate the types of assets or portfolios that their superannuation contributions are invested in, choosing between the following four investment strategies:

• Secure Fund: Australian fixed-interest securities and cash.
• Stable Fund: Primarily fixed-interest and bond securities, with a small exposure to ?domestic and overseas shares and property.
• Trustees' Selection Fund: Balanced fund of domestic and overseas shares, property assets and infrastructure and private equity investments.
• Shares Fund: Investment solely in domestic and overseas shares.

These strategies are distinguishable by their risk and return characteristics, with the Secure ?Fund being the least risky and likely to provide the lowest average return and the Shares Fund carrying the highest risk but being expected to provide the highest overall average return. For employees who choose the Investment Choice Fund, their final retirement payout is dependent on the returns generated by their chosen investment strategy and they bear the associated investment risk.

1. Outline what you think 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. Explain how the time value of money has an impact on the potential investment returns and retirement savings of participants in both the Defined Benefit Plan and the Investment Choice Plan. Would you be correct in saying that participants who opt for the Defined Benefit Plan are foregoing potential gains in investment earnings and returns generated in connection with the time value of money?