1. Why is it considered a rule of thumb to have 70% income replacement ratio? Explain.
Income replacement ratio is the percentage of the pre-retirement income that an employee
is likely to need to maintain a similar standard of life in retirement. In this rule of thumb, it is said
that an employee will need 70% of pre-retirement income to meet and maintain the standard of
living. The reason why only 70% of employees’ pre-retirement income is acceptable in retirement
is because some of the expenses that were incurred during the time of employment or earning an
income like other work-related expenses, will no longer be relevant. Income replacement ratio is
a good starting point to plan for the future when an employee is retiring. Employee are unlikely to
know and to have a very clear idea of the expenses in retirement, but there is no reason to not
save from the beginning.
2. What are the possible pros and cons of a DB pension, and the possible pros and cons of a DC
pension. These are on the standpoint of the employee, and you can also point out on the side of
the employer or company.
In Defined Benefit (DB) pension the employer normally promises the employee a specified
or pre-determined pension payment plan that can be received by the employee. This kind of
pension is defined based on the employee’s earnings history, age and on how long that the
employee works for the company. A DB pension gives the employee a fixed-payout that is not
based on the investment results, as it is determined using the agreed and explained formula that
considers such factors, which include earnings, length of employment, and age. The employee is
also not required to contribute to the retirement account, meaning there is no cost in the part of
the employee. But in the negative side, employees do not have any input on how the money is
invested. Also, the employee is expected to take a vested interest in the company and stay with
them for an extended period to receive their full benefits, as if the employee leaves early, he/she
would only receive a portion of their benefits or totally none.
In Defined Contribution (DC) pension the employee contribute to their own retirement
account, and the company or the employer will contribute a percentage to match the employee’s
contribution. A possible pros of DC pension is that, the employee may receive matching
contributions from employers. While on the other side, there is no way to know how much is an
employee may receive upon retiring.