What it means
Under a defined benefit plan the employer promises a specific pension, typically calculated from years of service, an accrual rate and final or career-average salary. The company must set aside and invest enough money to meet that promise, and if the investments fall short it has to make up the difference.
That open-ended obligation is why most private sector employers have closed these schemes to new members. Under a defined contribution plan the employer promises only the contributions, commonly a percentage of salary, and the employee's retirement income depends on how the invested pot performs and what it will buy at retirement.
The cost to the company is predictable and the investment and longevity risk sits with the employee. This shift of risk from employer to worker is the single biggest change in workplace pensions over recent decades.
Pension arrangements matter to the accounts as well as to staff. A defined benefit scheme appears on the balance sheet as the difference between the value of its assets and the present value of its promises, and that figure swings with interest rates and investment markets in ways unrelated to trading.
A deficit can restrict dividends, complicate a sale of the business and require a recovery plan agreed with trustees. Day to day, the plan is a recruitment and retention tool that employees compare directly with competitors.
A generous employer contribution, matched contributions that reward saving, and early enrolment all show up in retention statistics, while the total cost is a real part of employment cost that should be quoted alongside salary. Many jurisdictions now require automatic enrolment with minimum contribution levels.
Governance is the part that catches companies out. Schemes are typically run by trustees with legal duties to members rather than to the employer, so the company cannot simply direct the money, and decisions on funding, investment strategy and benefit changes usually require negotiation.
Sponsors that treat the trustee relationship as an afterthought tend to find their corporate plans, such as a sale or a large dividend, become far harder.
In practice
Real-world examples.
Example
A long-established engineering firm closed its defined benefit scheme to new joiners fifteen years ago but still pays $4,000,000 a year into it under a recovery plan. When the board proposes a special dividend, the trustees object, and the company agrees a larger contribution first.
Example
A professional services firm matches employee contributions up to 6% of salary and reports take-up in its annual review. Staff surveys show the match is the second most valued benefit after flexible working, and it costs less than the recruitment fees it displaces.
Example
A retailer automatically enrols new staff at the statutory minimum and finds that a quarter opt out within a year. It introduces a simple explanation of the employer contribution as deferred pay, and the opt-out rate falls to below one in ten.
Formula
Calculation
Annual defined benefit pension = years of service x accrual rate x pensionable salary
Take an employee retiring after 30 years with a final pensionable salary of $80,000 in a scheme with an accrual rate of one-sixtieth, which is 1.5% of salary for each year served. The pension is 30 x 1.5% x $80,000, and 30 x 1.5% = 45%, so the pension is 0.45 x $80,000 = $36,000 a year, or $36,000 / 12 = $3,000 a month before tax.
If the pension were paid for 25 years, the nominal total would be $36,000 x 25 = $900,000, which shows the scale of the promise the employer has made for one person. In reality the cost is higher again, since most schemes increase payments with inflation and pay a reduced pension to a surviving spouse.
Compare that with a defined contribution arrangement for the same employee. If the company pays 8% of salary, its annual cost is 0.08 x $80,000 = $6,400 and it is fully discharged; the eventual income depends on investment returns and the employee's own contributions, and the employer carries no further obligation.Case study
Seen in the real world.
This is an illustrative and fictional case. Colworth Castings, an invented foundry group with 700 staff, ran a defined benefit scheme that had been closed to new members for a decade but still covered 340 former and current employees. A fall in long-term interest rates increased the present value of its promises, turning a small surplus into a deficit of $18,000,000 in a single year.
Nothing had changed in the trading business, but the balance sheet looked far weaker, the bank asked questions about covenants, and a planned acquisition was postponed. The company agreed a ten-year recovery plan with the trustees of $2,200,000 a year, backed by a charge over its main site.
In this fictional example the board's later reflection was that the deficit had been visible in the actuarial reports for years and simply not discussed at board level. It added a pension update to every second board meeting, which did not change the numbers but did stop them arriving as a surprise.
Watch out
Common mistakes.
- Treating a defined benefit deficit as an accounting quirk, when it is a real cash obligation that can restrict dividends, borrowing and the sale of the business.
- Quoting salary without the employer pension contribution, which understates the true cost of employment and undersells the package to candidates.
- Assuming the company controls the scheme's money, when trustees have legal duties to members and make funding and investment decisions in their interest.
Questions
People also ask.
What is the difference between defined benefit and defined contribution?
Defined benefit promises a set income and leaves investment and longevity risk with the employer, while defined contribution promises only contributions and leaves that risk with the employee.
Why do pension deficits move so much?
Because the value of future promises is calculated using long-term interest rates, so a small fall in rates can add a great deal to the present value of the liability.
Is the employer contribution really part of pay?
In substance yes, since it is deferred remuneration earned now and paid later, which is why total reward statements show it alongside salary.
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