What Is Defined-Benefit Pension Scheme?

An in-depth look into Defined-Benefit Pension Schemes, their structure, importance, and evolving landscape in the retirement planning industry.

A Defined-Benefit Pension Scheme (DB scheme) is an occupational pension scheme in which the rules specify the benefits to be received on retirement, and the scheme is funded accordingly. The benefits are normally calculated using a formula incorporating years of service and salary levels. This stands in contrast to defined-contribution schemes, where the benefits depend on the contributions made and the investment performance of those contributions.

Historical Context

Defined-Benefit Pension Schemes have a long history, with origins tracing back to ancient Rome. However, they became particularly prominent in the 20th century, especially post World War II, when many corporations and governments established robust pension plans as part of employment benefits.

Types and Categories

• Final Salary Scheme: A DB scheme where the retirement benefit is based on the salary at the end of the employee’s career and years of service.
• Career Average Revalued Earnings (CARE) Scheme: This type calculates pension benefits based on the average earnings throughout the career, adjusted for inflation.

Key Events

• 1980s-1990s: Widespread adoption of DB schemes.
• Early 2000s: Increasing awareness of the underfunding and growing liabilities led many employers to reconsider the sustainability of DB schemes.
• Present: Transition to defined-contribution schemes due to rising costs and regulatory changes.

Detailed Explanations

Formula for Benefits Calculation

The formula for calculating DB benefits typically includes:

$$ \text{Annual Pension} = \frac{\text{Final Salary} \times \text{Years of Service} \times \text{Accrual Rate}}{100} $$

Where:

• Final Salary is the employee’s salary at retirement.
• Years of Service refers to the number of years the employee has worked for the employer.
• Accrual Rate is the percentage of the final salary that the employee earns as a pension for each year of service.

Accounting Standards

• FRS 102 Section 28: Sets out the accounting regulations in the UK and Ireland.
• IAS 19: International Accounting Standard 19 covers Employee Benefits, providing guidelines for accounting and disclosure.

Importance and Applicability

DB schemes are crucial for providing financial security in retirement, promising a fixed and predictable income based on service and salary history. They are particularly beneficial in sectors with stable, long-term employment.

Examples

• Public Sector: Many government employees benefit from DB schemes.
• Large Corporations: Historically offered by manufacturing giants and blue-chip companies.

Considerations

• Funding Status: Regular actuarial valuations are necessary to ensure the scheme is adequately funded.
• Longevity Risk: Longer lifespans can increase the financial burden on the scheme.
• Economic Conditions: Low-interest rates can reduce the return on investments, increasing funding requirements.

Related Terms

• Defined Contribution Pension Scheme: A retirement plan where the benefits are based on contributions and investment performance.
• Actuarial Valuation: Assessment of a pension plan’s financial health.
• Pension Fund: The pool of assets forming the pension plan.

Comparisons

• DB vs. DC Schemes: DB provides guaranteed income, while DC is dependent on contributions and investment performance.
• Final Salary vs. CARE: Final Salary schemes are based on the last salary, while CARE considers average earnings.

Interesting Facts

• Many DB schemes have been closed to new entrants due to high costs.
• Some countries mandate certain types of pension schemes, influencing the prevalence of DB plans.

Inspirational Stories

• The Story of UAW: The United Auto Workers negotiated significant pension benefits for auto industry employees in the mid-20th century, exemplifying union power and the push for worker security.

Famous Quotes

“Retirement is wonderful if you have two essentials — much to live on and much to live for.” — Unknown

Proverbs and Clichés

• “Save for a rainy day.”
• “A penny saved is a penny earned.”

Expressions and Jargon

• Underfunding: When a pension plan doesn’t have enough assets to meet its future liabilities.
• Pensionable Earnings: The portion of an employee’s salary used to calculate pension contributions and benefits.

FAQs

Q: Why are many DB schemes closed to new members? A: Rising costs and financial risks have led many employers to prefer defined-contribution schemes, which transfer investment risk to employees.

Q: How is my pension from a DB scheme protected? A: In many countries, government insurance programs or pension protection funds provide safety nets to secure pensions in case of employer insolvency.

References

1. Financial Reporting Standard 102, Section 28: “Employee Benefits.”
2. International Accounting Standard 19: “Employee Benefits.”
3. U.S. Department of Labor: “Understanding Your Retirement Plan.”

Summary

The Defined-Benefit Pension Scheme remains an integral part of retirement planning, providing financial security based on predefined criteria. While their prevalence has waned in recent years due to financial sustainability issues, they continue to play a critical role in sectors where long-term employment is common. Understanding the mechanics, importance, and challenges of DB schemes can guide both employers and employees in making informed retirement planning decisions.