What it means
There are two broad types. In a defined benefit plan, the employer promises a specific retirement income, usually calculated from final or average salary and years of service, and carries the investment risk.
In a defined contribution plan, the employer (and often the employee) pays set amounts into an individual account, and the retirement income depends on how those investments perform. For the business, a pension is a cost of employing people, but it also creates a liability.
A defined benefit plan means the company owes future payments that may stretch decades ahead, so actuaries (specialists who estimate long-term obligations using life expectancy and financial assumptions) work out how much needs to be set aside today. If the plan's assets fall short of the estimated obligation, the shortfall appears on the balance sheet as a deficit.
Funding is usually handled through a separate pension trust or fund so the money is ring-fenced from the company's own creditors. The fund's trustees invest the contributions in shares, bonds and other assets, and regulators typically require regular valuations.
A company with a large deficit may have to make extra payments, which can squeeze cash flow just when it can least afford it. Because of that risk, many employers have moved away from defined benefit plans for new staff and now offer defined contribution plans instead.
The cost becomes predictable, because the company simply pays a fixed percentage of salary, and the investment risk moves to the employee. Existing defined benefit promises, however, remain in place and continue to affect valuations, takeover discussions and credit ratings.
Employees should look at what the employer contributes, any matching arrangement, how long they must work before the benefits are theirs (known as vesting) and what happens if they leave early. Those details often matter more than the headline plan name.
In practice
Real-world examples.
Example
A manufacturing firm with a long-established defined benefit plan reports a $15,000,000 deficit in its accounts. The finance director schedules extra annual contributions of $2,000,000 so the gap is closed over about eight years.
Example
A start-up with 25 employees offers a defined contribution plan where it pays 5% of each person's salary into an investment account. The founders like it because the cost is fixed and appears simply as a payroll line.
Example
A large retailer is taken over, and the buyer's due diligence team spends weeks reviewing the target's pension fund. They reduce the offer price by the size of the deficit because they will inherit the obligation.
Formula
Calculation
Defined benefit annual pension = Accrual rate x Years of service x Final salary
Defined contribution employer cost = Salary x Employer contribution rate
An employee has worked for 30 years, earns a final salary of $80,000 and the plan has an accrual rate of 1.5% per year of service.
Annual pension = 0.015 x 30 x $80,000 = 0.45 x $80,000 = $36,000 a year.
For the defined contribution comparison, an employer contributes 6% of an $80,000 salary: $80,000 x 0.06 = $4,800 a year, which is the employer's full annual cost, with no promise about the final pot.Case study
Seen in the real world.
Marlowe Foods is an illustrative, fictional food producer that has run a defined benefit pension for forty years. Falling interest rates in the story pushed up the estimated value of the promised pensions, and the plan slid into a deficit of $9,000,000 while profit was flat.
The board closed the plan to new joiners, offered newcomers a defined contribution plan with a 6% employer contribution, and agreed a recovery schedule with the trustees. The deficit payments reduced free cash flow, so the company postponed a new packaging line by a year.
The illustrative lesson is that a pension promise is a debt in disguise. The firm that treated it as an ordinary payroll cost found out the hard way that it behaves more like a loan with a very long maturity.
Watch out
Common mistakes.
- Treating a pension plan as simply a staff benefit cost, when a defined benefit plan creates a large long-term liability that can affect borrowing and valuation.
- Assuming the employer is always responsible for investment losses, when in a defined contribution plan the employee carries that risk.
- Ignoring vesting rules, then being surprised that employer contributions are lost on leaving early.
Questions
People also ask.
What is the difference between defined benefit and defined contribution?
A defined benefit plan promises a set income at retirement, while a defined contribution plan promises only the contributions and leaves the final pot to investment performance.
Does the company have to fund a deficit?
Usually yes, regulators and trustees expect a recovery plan that closes the gap within an agreed period.
Can a company take money back out of a pension fund?
Generally only in tightly regulated circumstances, because the assets are ring-fenced for members.
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