Volatility term structure is believed to be a common phenomenon across asset classes. In equity indices, it’s well-known that implied volatility (IV) is generally greater than realized volatility (RV) (i.e. there exists a so-called volatility risk premium), and out-of-the-money (OTM) IV is greater than at-the-money (ATM) IV (i.e. there exists a so-called volatility skew). The existence of the volatility risk premium makes developing long volatility strategies a very difficult, if not impossible, task. Similarly, volatility skew makes tail risk hedging expensive.

Many studies have been carried out on the US equity indices. Little research has been devoted to international equity indices. Among few studies, Reference [1] examines the volatility structure of the DAX index. Specifically, it investigates PnLs of delta-hedged short options trading strategies. One of the simulated strategies is as follows,

Delta-neutral hedge without transaction costs. Hedge-volatility equal to the implied volatility of an option. Options are sold at bid/ask midpoint and DAX-index is traded at the closing price of DAX 30.

Table 19 of Reference [1] summarizes the PnL of the above strategy. From the results, we observe that,

• For Deep OTM options, their PnLs are consistent with ours,
• For OTM put options, 1-Month delta-hedged short options show negative PnL; this means that we would be able to design a cheap tail hedge,
• Results for ATM options are even more surprising. Except for 3-Month put options, all other ATM options yielded negative PnL. This means that we would be able to design long-volatility trading strategies that have positive expectancies [2].

In short, the results are quite surprising. This may be due to the followings,

• DAX volatility term structure is different from SP500’s,
• The period covered by data used in the study was not long enough. The options data covers only the 2018-2019 period.

We believe that #2 is likely the cause. It’s well-known that after the crash of February 2018, US equity indices’ RVs exceeded IVs, thus making short volatility trading strategies such as butterflies unprofitable. To make any conclusion regarding #1, more data should be used.

References

[1] J. Juvakka, Profit potential of DAX index option trading based on implied volatility surfaces, LUT School of Business and Management, 2020.

[2] Transaction costs are not accounted for.

Originally Published Here: Volatility Term Structure of the DAX Index

Lenders assess various factors when providing a loan to a borrower. These factors may include the borrower's credit ratings, history, security offered, etc. Based on this evaluation, lenders decide on whether to provide the loan or not. It also helps lenders measure the return they want to get from the loan. Apart from the nominal interest rate, lenders may also charge a default risk premium.

What is the Default Risk Premium?

Default risk premium represents the difference between the risk-free rate and a debt instrument's interest rate. In essence, it is the additional interest lenders charge on their debt instruments to compensate for the related risks. Through this premium, lenders can receive higher interest on debts that are riskier than others. The default risk premium may differ depending on several factors.

The default risk premium on a debt instrument is directly proportional to the default risk on it. For every borrower, this risk will differ. Therefore, lenders will decide how much default premium they will charge for each loan. For the lender, the default risk premium acts as a reward for the risk undertaken on any debt transaction.

How does the Default Risk Premium work?

As mentioned above, the default risk premium is the additional interest borrowers pay above the risk-free rate. Every corporation or borrower has to pay a default risk premium on debt transactions. It is because there is always an inherent risk for borrowers to default. In theory, it implies that any entity that does not have a default risk will pay the risk-free rate on debt instruments.

As mentioned above, the default risk premium on debts depends on the default risk for it. The higher this risk is, the more the default risk premium lenders will charge. However, the default risk isn't the only factor that dictates the rates that lenders will charge. Borrowers will also make a decision on whether to avail of a loan or not based on the default risk premium.

What is the Default Risk Premium on the Corporate Bond?

The default risk premium on the corporate bond represents its interest rate above the risk-free rate. For every corporate bond, the default risk premium will differ. Usually, it depends on the bond's credit rating, which it gets from credit rating agencies. Usually, the higher the rating is, the lower the default premium will be. It is because higher rating bonds are less susceptible to default. Therefore, investors take a minimal risk with these.

For investors investing in corporate bonds, the default premium is the yield they get above government bond yields. For a better comparison, investors must calculate the default risk premium on a corporate bond by comparing it to identical government bonds. Therefore, the face value, coupon, and maturity of both bonds must be similar.

How to calculate the Default Risk Premium on the Corporate Bond?

As mentioned above, the default risk premium on the corporate bond is the difference between its coupon rate and the risk-free rate. Therefore, the default risk premium formula will be as below.

Default Risk Premium = Coupon rate of corporate bond - Risk-free rate of interest

For example, a company issues a bond to the public with a coupon rate of 5%. The risk-free rate of interest in the market is 3%. Therefore, the default risk premium on the corporate bond will be 2% (5% - 3%).

Conclusion

For every debt transaction, lenders have to undertake several risks, including default risk. The default risk premium is the compensation that lenders receive for the default risk they take on debts. It represents the difference between the risk-free rate and the interest rate on the debt instrument in consideration. The higher the default risk is, the higher the default risk premium will be.

Article Source Here: What is the Default Risk Premium on the Corporate Bond?

Inflation is the decline in the purchasing power of a given currency over a specific time. Usually, it represents the rate at which the price level of a basket of selected goods and services in an economy increase. The selection of this basket will depend on the index which measures the inflation rate. For most countries, experiencing inflation is common from one year to another.

While inflation can have positive effects, some people consider it to be detrimental to the economy. However, it is natural for economies to go through inflation regularly. Inflation also causes a currency’s value to fall, which translates to the loss of purchasing power. There are two primary reasons why inflation may occur. These include demand-pull and cost-push inflation. In some cases, inflation can also be negative.

Can Inflation be negative?

While it is common for most economies to experience a regular rise in prices, inflation can also be negative. In that case, the purchasing power of a currency will increase while item prices will fall. This process is known as deflation or negative inflation. Deflation is not as common as inflation. While it is the opposite of inflation, deflation can also adversely affect an economy or currency.

What is Deflation?

Deflation is when the prices of goods and services fall in an economy. It also accompanies a rise in the purchasing power of the currency. Deflation occurs when the demand for goods or services falls in the economy or when the supply exceeds it. In other circumstances, the money supply in the economy also affects whether it will experience inflation or deflation.

Deflation can be beneficial for the people in the economy. However, it may also signal a future recession. When the prices of goods and services in the economy fall, people may not prefer to spend. It is because they usually wait until these prices fall even further. However, this may also cause other economic issues, such as declining jobs, unemployment, lower supply, etc.

How does Deflation work?

Like inflation, the Consumer Price Index (CPI) can help measure deflation. Deflation occurs due to two primary reasons. Firstly, it arises from the increase in the aggregate supply in an economy. If there is no demand to meet the increased supply, deflation will occur. It is also another cause of deflation. When the aggregate demand in an economy falls, deflation will occur.

There are even further causes of deflation. It may include a reduction in the money supply in an economy, lower production costs, technological advancements, etc. In most of these cases, the aggregate supply and demand will fluctuate, which will also cause deflation. Several periods of continuous deflation can cause the economy to suffer from a recession.

There are several factors that may indicate the occurrence of deflation in an economy. These include a decrease in the price of goods or services and an increase in unemployment or job losses. On top of that, an increase in interest rates in an economy also indicates deflation. Once these events take place, they can give rise to a ripple effect, causing a recession.

Conclusion

Inflation represents the increase in the price level of goods and services over a specific time. It also causes the loss of purchasing power for a currency. Inflation can also be negative, known as negative inflation or deflation. Deflation is when the purchasing power of a currency increase over time. While deflation is theoretically positive, it can cause several problems, leading to a recession.

Article Source Here: Can Inflation Be Negative?

For investors, investing in various assets or income streams presents several risks. These risks can be specific to the asset class or the market that investors enter. Some risks may apply to all investments regardless of the type of asset or market. One of these risks includes inflationary risk associated with inflation in an economy.

What is Inflationary Risk?

Inflationary risk represents the uncertainty associated with inflation affecting the future value of an investment or asset. Inflationary risk comes with inflation, which is the rise in prices in an economy. It also causes the loss of purchasing power. Therefore, the inflationary risk is the risk that an increase in prices or reduction in purchasing power impacts asset or investment value.

For investors, it is crucial to ensure that the returns from any investment at least exceed the inflation rate. If it doesn’t, then the investment is loss-making. Similarly, it results in a reduction in the value of the investment. Therefore, inflationary risk can cause investors to lose money on their investments. This risk depends on how inflation fluctuates in an economy. Investors will also require an inflation premium for the inflation risk they take.

What is Inflation Premium?

Inflation premium represents the compensation that investors require to make on investments impacted by inflation risk. Inflation premium is a component of the required return. With an inflation premium, investors can earn from these risks of loss of purchasing power or increasing prices. It arises from investors holding nominal assets that suffer due to unanticipated changes in inflation.

Investors require an inflation premium to compensate them for the risk they take associated with inflation fluctuations. Since these risks are unpredictable, investors use the inflation premium to account for such uncertainty. Inflation premium represents an interest rate that investors can add to the real risk-free rate to compensate for fluctuations in inflation.

How to calculate the Inflation Premium?

Investors can calculate the inflation premium by taking the ratio of two identical bonds. One of these bonds must carry inflation risk while the other doesn't. In most cases, investors can use government bonds to calculate the inflation premium. Some treasury bonds come as inflation-protected. Therefore, these bonds account for inflation in both the face value and coupon payments.

Investors can use these inflation-protected treasury bonds and compare their yield to the yield from nominal treasury bonds. This way, they can calculate the inflation premium. In this case, the inflation premium formula will be as follows.

Inflation Premium = Yield on treasury bonds - Yield on inflation-protected treasury bonds

Investors can also calculate the inflation premium through nominal and real rates. The formula for inflation premium using these rates is as follows.

Inflation Premium = (1 + Nominal Rate / 1 + Real Rate) - 1

Example

The treasury yield curve for 10-year bonds on 03 May 2021 was 1.63%. The real treasury yield curve for 10-year bonds on the same date was -0.79%. Therefore, the inflation premium at the time will be as follows.

Inflation Premium = Yield on treasury bonds - Yield on inflation-protected treasury bonds

Inflation Premium = 1.63% - (-0.79%)

Inflation Premium = 2.42%

Conclusion

Inflationary risk represents the risk that investment values will fluctuate due to fluctuations in the inflation rate. Inflation premium is the compensation that investors can expect for these fluctuations. It arises from the fact that investors hold nominal assets which are subject to inflation. Investors can calculate the inflation premium using one of the two ways discussed above.

Originally Published Here: What is Inflation Premium?

Every investment comes with risks, which also dictate the returns that investors can expect on it. Usually, investors expect to earn returns that exceed the income they will get for zero-risk investments. For that purpose, they can use the risk-free rate. This rate also adjusts for any inflation changes in the economy.

Sometimes, however, investors may want to calculate their rate of return without accounting for inflation. For that purpose, they can use the real risk-free rate. Before looking at the real risk-free rate, it is crucial to understand what the risk-free rate is.

What is the Risk-Free Rate?

The risk-free rate is a theoretical rate of return on an investment that does not carry any risk. However, every investment includes some form of risk. Therefore, the risk-free rate usually represents the rate of return on treasury bonds or other government securities. While these carry some risk, these risks are negligible and qualify them for usage at risk-free rates.

The risk-free rate is not achievable in practical conditions. However, these allow investors to analyze the returns they get on their investments. The risk-free rate is also predictable, making it a great tool for investors. The risk-free rate is beneficial in several models and calculations. For example, investors can use it to calculate the risk premium on their investments. The risk premium, in turn, is a part of the Capital Asset Pricing Model, Sharpe Ratio, and Treynor ratio.

What is the Real Risk-Free Rate?

The real risk-free rate is a risk-free rate that removes inflation from the risk-free rate. While the risk-free rate does not include any risks, the risk of inflation is inherent to it. By excluding inflation from this rate, investors can better analyze their returns on investments. As with the risk-free rate, the real risk-free rate is not achievable and is a theoretical concept.

In essence, the real risk-free rate is the rate of return that investors can expect on a zero-risk financial instrument without inflation. Although it is a theoretical rate, investors can calculate the real risk-free rate using the risk-free rate and vice versa. The relationship between the nominal and real rate depends on the inflation rates.

How to calculate the Real Risk-Free Rate?

Investors can calculate the real risk-free rate by subtracting the expected inflation rate from the nominal risk-free rate. The real risk-free rate formula is as below.

Real Risk-Free Rate = Risk-Free Rate - Expected Inflation

For example, the U.S. 10 Year Treasury Note was 1.640% on May 18, 2021. As mentioned, while this note isn’t wholly risk-free, it is still substitutable for the risk-free rate. Similarly, the expected inflation during April 2021 was 4.2%. Therefore, the real risk-free rate for the period will be as follows.

Real Risk-Free Rate = 1.64% - 4.2%

Real Risk-Free Rate = -2.56%

In the above example, although the risk-free rate is positive, the real risk-free rate is negative. It is because the inflation rate exceeds the risk-free rate. Furthermore, this difference suggests that the investors will lose money on risk-free investments.

Conclusion

The risk-free rate represents a rate at which investors can expect to earn income on risk-free investments. However, this rate is theoretical and impractical. Investors can, nonetheless, use the rate on Treasury notes to substitute for this rate. The real risk-free rate represents the rate of return on zero-risk investments without inflation.

Article Source Here: What is the Real Risk-Free Rate?

What is an Endowment Fund?

An endowment fund represents a restricted financial asset. Endowment funds are common among nonprofit organizations. These contain capital investments and any income leveraged by the nonprofit organization to fund the overall mission. For endowment funds, nonprofit organizations can only use the earnings made through them. They cannot use the underlying investment that constitutes the endowment fund.

Endowment funds, like any other funds, need management. Therefore, professional fund managers oversee the funds to ensure it performs as expected. For endowment funds, the initial capital investment comes from donations. These donations are tax-deductible for the donors. It is common for organizations such as hospitals, universities, and schools to use endowment funds.

How do Endowment Funds work?

Endowment funds begin with charitable contributions from donors to a trust. These donors invest in the trust for a specific purpose. Using a trust structure for donations helps segregate the underlying organizations from the funds. However, these donors are not the beneficiaries of the endowment funds. It does not behave similarly to other typical funds. Instead, the beneficiary of endowment funds is a nonprofit organization.

Endowment funds may consist of several types of investments. These include cash, stocks, bonds, commodities, etc. The fund manager decides on which investments will be a part of the endowment funds. The amount initially invested in an endowment fund always remains intact. However, any investment income from the funds is available for use.

Endowment funds usually aim to serve a purpose. This purpose comes from the donors who specify the reason for making any donations to these funds. Once they donate their money to the endowment fund, these funds become restricted. The fund manager may also need to spend a portion of the investment income on these funds to ensure the original funds grow over time.

What are the advantages of Endowment Funds?

Through endowment funds, many nonprofits can raise money for charitable causes. These funds help new nonprofit organizations in generating funds while also giving them a source of continuous funds. With endowment funds, nonprofit organizations can diversify their income and reduce the risks associated with volatility in the economy.

For the donors, endowment funds are also a viable option to support causes in which they believe. They can restrict these funds, ensuring the funds get used for their specified purpose only. On top of that, any donations to endowment funds are tax-deductible, making them a great option for tax planning. Overall, endowment funds can be beneficial for both donors and nonprofit organizations.

What are the disadvantages of Endowment Funds?

Despite many advantages, endowment funds also have some drawbacks. Some endowment funds come with unrealistic endowments. These organizations may face criticism for their use of resources or requiring more funds. On top of that, endowment funds also undergo the same process as other funds as these involve investments. Whether the endowment fund grows depends on how the underlying investments perform.

Some nonprofit organizations may not have the resources to manage endowment funds. While they have the option to hire investment managers, these come with additional costs. On top of that, there are some other regulatory compliances that these organizations need to consider. Therefore, endowment funds can be costly to manage.

Conclusion

Endowment funds represent restricted financial assets comprising donations from donors into a trust. These funds exist to serve a specific purpose. The money in endowment funds always remains intact. However, organizations can use any investment income from it. There are several advantages and disadvantages of endowment funds, as mentioned above.

Post Source Here: How Does an Endowment Fund work?

Most of the studies on time-series momentum have been performed in the daily, weekly, and monthly timeframes. Relatively less research has been conducted in the intraday timeframe. So naturally, we would ask the question: Does the momentum exist intraday?

Reference [1] examined the time-series momentum of the SP500 index in the intraday timeframe. It concluded that the momentum indeed exists intraday. Specifically, the authors pointed out that the first half-hour return on the market since the previous day’s market close predicts the last half-hour return.

Our paper documents that the market return in the first half-hour predicts the market return in the last half-hour. This intraday predictability is statistically significant both in- and out- of-sample. In terms of market timing and asset allocation, the economic gains of using the predictability are substantial.

They also found that the return predictability is stronger on high-volatility days. Further, the time-series momentum exists not only in the SP500 index but also in other broad market and sector indices.

We also find that the market intraday momentum is stronger on high volatility days, high trading volume days, recession days, and important economic news (MCSI, GDP, CPI, FOMC) release days. Moreover, the intraday momentum is strong not only for the S&P 500 ETF, but also for ten other most actively traded ETFs. Theoretically, the market intraday momentum is consistent with the trading behavior of investors who either infrequently rebalance their portfolios, or trade late from early information.

The implication of this article is useful not only for high-frequency traders but also for options and portfolio risk managers. Since the SP500 index is highly correlated with the volatility index, i.e. VIX, one can use the results of this article to design better options trading and hedging strategies.

Finally, based on our experience, we believe that the intraday time-series momentum also exists in other markets than equities such as commodities, interest rates.

References

[1] L Gao, Y Han, SZ Li, G Zhou, Market intraday momentum,  Journal of Financial Economics, 129, 394-414, 2018

Article Source Here: Does Intraday Momentum Exist in Stock Indices?

A fund represents a pool of money collected by investors that aims to meet a particular purpose. There are various types of funds that have specific goals. Based on these goals, investors can select a fund and invest in it. Usually, investors also appoint an investment fund manager responsible for managing the fund according to the fund's purpose.

What is an Investment Fund Manager?

An investment fund manager is a person, group of persons, or a firm responsible for ensuring a fund meets its investing strategy. The manager also overlooks the whole portfolio and manages it accordingly. The investment fund manager acts and makes decisions on behalf of their clients, who are investors. Their goal is always to achieve the highest returns on any funds.

When managing a portfolio, investment fund managers consider various factors. These may include their clients' goals, risk tolerance levels, expected returns, etc. In exchange for managing these funds, these managers receive compensation. This compensation usually depends on how well the underlying funds perform. Some fund managers may also get a fixed payment. However, a substantial portion of their income is performance-based.

What does an Investment Fund Manager do?

Investment fund managers are responsible for various activities when handling funds. Most of these responsibilities relate to how they manage their clients' funds. Some of the primary duties that investment fund managers undertake are as below.

Analyzing and selecting investments

As mentioned above, investment fund managers are responsible for investing on their clients' behalf. For that purpose, they need to analyze various investments. Similarly, they will have a goal that is common for the fund. Based on this goal, they will choose appropriate investments to include in the funds. Investment fund managers also aim to analyze and select investments that maximize returns for investors.

Managing funds

Investment fund managers also need to manage their funds actively. It is one of their primary responsibilities as a fund manager. This responsibility will include directing client investment activities within the fund for stocks, debt instruments, and other securities. Similarly, they need to decide which securities they need to incorporate into the fund's product mix.

Monitoring performance

Investment fund managers are also responsible for monitoring investments incorporated within a fund. For this, they need to decide which investments meet the fund’s purpose and how it performs. They will also identify any shortcomings and develop strategies to offset losses. Based on this analysis, they will make decisions on whether to keep those investments or sell them.

Managing risks

Investment fund managers are also responsible for managing the fund’s overall risks. They need to ensure these risks are in line with investors’ risk tolerance levels. Investment fund managers usually set the risk level at the beginning of their work. This responsibility also includes using diversification strategies to avoid potential from specific assets or asset classes.

Complying with regulations

On top of the duties, investment fund managers need to ensure their activities follow the set regulations. These regulations may include industry regulations and best practices. By doing so, investment fund managers can ensure they don't have to pay any fines or penalties.

Conclusion

Investors can pool their investments into funds that meet specific objectives. Usually, an investment fund manager is responsible for managing these funds. Investment fund managers also analyze and select investments, manage the funds, monitor the performance, manage risks and comply with regulations.

Originally Published Here: What does an Investment Fund Manager do?

Most companies offer their employees pension plans which allow those employees to earn after retirement. These companies manage any contributions through investments. The employer invests these amounts on the employee's behalf. These earnings then generate income, which funds future pension payments to employees. Companies may also hire an investment committee to look after these plans.

What is an Investment Committee?

An investment committee represents a committee responsible for planning and overseeing an investment plan. Usually, companies use investment committees to manage retirement plans. However, these committees also have other responsibilities. The scope of their work depends on the company and its needs. However, investment committees can handle all sorts of responsibilities associated with investments.

Investment committees are only responsible for planning and oversight. Usually, a company's Chief Investment Officer performs the duties associated with managing investments. Therefore, both a company's CIO and its investment committee must work in unison to achieve its investment goals. Unlike some other committees, having an investment committee is not mandatory. However, companies may still establish one as a part of their risk management strategy.

What does an Investment Committee do?

As mentioned, the scope of the work that an investment committee performs depends on the company. Typically, however, some of the common responsibilities that the members of an investment committee share are as follows.

Develop investment policy

The primary role of an investment committee within any company is to help establish an investment policy. The committee does so through a written document known as the investment policies statement. This policy signifies what investment the company needs to make, how it should manage those investments, and how to choose its managers. The investment policy statement also defines the criteria for measuring the plan’s performance.

Gauge investment performance

The investment committee, due to its oversight responsibility, is also responsible for gauging investment performance. The committee overlooks every investment and measures its performance against the criteria defined in the investment policy statement. The committee also tracks changes in the investment management team, the fees and expenses for it, the investment style, and much more.

Manage implementation of investment strategies

The investment committee not only defines the investment policies for a company but also manages the implementation. While the committee cannot finalize investments, all these decisions must get approved by the investment committee. Usually, they assess whether the investment meets the objectives set in the investment policy statement.

Perform financial reviews

The investment committee within a company is also responsible for reviewing the financial aspects of an investment. As mentioned, they usually compare these financials with the expected amounts according to the investment policy statement. The investment committee also prepares a report that it then presents to the board of directors.

Ensure regulatory compliance

The investment committee is also responsible for ensuring a company complies with all applicable regulations. However, these regulations only apply to investments. As mentioned, the investment committee is usually responsible for pension plan management. In that case, the committee is responsible for ensuring compliance with The Employee Retirement Income Security Act.

Conclusion

When companies make an investment, they may hire an investment committee to plan and oversee the operations. This committee usually helps companies with pension plan management but can also perform other duties. Within any company, investment committees have several responsibilities. Some of these responsibilities are above.

Article Source Here: What Does an Investment Committee Do?

Pension or retirement plans are typical for employees working in companies. Through these plans, they can ensure they receive income after retirement. There are several retirement plans where they, their employer, or both contribute an amount. Some plans offer a fixed contribution upon retirement. However, some others come with uncertain future income. One such retirement plan is the profit-sharing plan.

What is the Profit Sharing Plan?

The profit-sharing plan is a pension plan in which the employee receives a share of the company's profits as benefits. Another name used for this plan is the deferred profit-sharing plan. Each employee registered in this plan gets a portion of the company profits. The company sets a percentage for them, and their benefits depend on the company's annual or quarterly earnings.

Although profit-sharing plans offer varying incomes, they have a higher motivational impact on employees. Due to the variable income received by employees, the profit-sharing plan falls under the category of the defined contribution plan. The employee makes specific contributions during their employment. The company or their employer can also choose to contribute to the scheme.

Profit-sharing plans aren't restricted retirement plans. Companies may also offer other retirement plans, such as IRAs alongside these plans. The company also chooses the terms for the profit-sharing scheme. On top of that, the company can set the qualifying criteria for employees who can join this plan. Companies don't have to be profitable to offer these plans.

How do Profit-Sharing Plans work?

Profit-sharing plans work similarly to other defined-contribution schemes. With profit-sharing plans, employees can make contributions to the plan. Usually, these contributions are specific. As mentioned, the employer may also choose to contribute to the plan, although it isn't mandatory. Any contributions go to a qualified tax-deferred retirement account which allows penalty-free distributions.

After retiring, employees can receive their share of profits. These benefits usually start after the employee has reached the age of 59 and a half. Profit-sharing plans allow employees to choose between either cash compensations or company stock.  Some profit-sharing plans also provide employees with loans, which they can take before their retirement age.

The company offering such plans decides on how much each employee will get allotted. It can use a formula for profit allocation. The company can also adjust the plan as needed. Using this, the company can determine the total of the overall employees' compensation. After that, it is possible to find each employee's percentage by dividing each employee's annual compensation by that total.

What are the advantages and disadvantages of Profit Sharing Plans?

Profit-sharing plans can be significantly beneficial to both the company and its employees. Through these plans, companies can keep their employees motivated and gain a competitive advantage. Profit-sharing plans align the company’s objectives with those of the employee. Overall, the efficiency and productivity rates within the company can increase substantially.

However, profit-sharing plans can also be demotivating. When some employees receive higher profit portions, others will become demotivated. Similarly, these plans can introduce additional costs, which can impact a company's operations. On top of that, employees get no guarantee they will receive income in the future if the company makes losses.

Conclusion

Profit-sharing plans are retirement plans in which employees can receive a portion of the company's profits on retirement. These plans are a type of defined-contribution plan. The company that set up this plan decides on its terms and how much each employee will receive. Profit-sharing plans can be beneficial but may also come with some disadvantages.

Originally Published Here: How do Profit-Sharing Plans work?