What it means
In a defined benefit plan, the pension an employee will receive is set by a formula. A typical formula multiplies the years of service by an accrual rate, which is a percentage of pay earned for each year worked, and by a salary measure such as final salary or career average pay.
The result is a pension for life, sometimes with a spouse's benefit and increases for inflation. The employer pays money into a fund, which is invested to meet the promised benefits.
Actuaries, who are specialists in long-term risk calculations, estimate how much is needed using assumptions about life expectancy, salary growth, inflation and investment returns. If the fund holds less than the estimated liability, the plan is in deficit, and the employer may have to pay extra contributions.
For a company, the plan creates a large and uncertain obligation. A small change in the discount rate, which is the interest rate used to turn future payments into a value today, can move the reported liability by millions of dollars.
Longer life expectancy and falling investment returns also increase the cost. For this reason many employers have closed their defined benefit plans to new members and moved to defined contribution plans, in which the employer pays a set amount and the employee carries the investment risk.
Existing plans still matter enormously in company accounts, in takeover negotiations and in credit analysis. Pension deficits are often treated like debt by lenders and rating agencies.
They also feature in sale negotiations, because a buyer inherits the funding responsibility. Smart buyers ask for the latest actuarial valuation early, as the deficit can change the price they are prepared to pay.
Employees benefit from certainty, but the quality of the promise depends on the strength of the employer and the funding of the plan. Many countries have protection schemes or regulators to reduce the risk of members losing out if a company fails.
Members should still check the funding position of their plan.
In practice
Real-world examples.
Example
A manufacturer's workers earn a pension based on their final salary and years of service. After 25 years, an employee knows exactly how her pension will be calculated, regardless of how the stock market performs. The employer carries the risk of any shortfall in the fund.
Example
A company in a takeover discovers that the target's pension fund has a $50,000,000 deficit. The buyer reduces its offer price, because it will have to fund the shortfall over the coming years.
Example
A finance director sees the reported pension liability rise sharply after a fall in the discount rate. She explains to the board that the cash needed has not changed much, but the accounting liability is higher.
Formula
Calculation
Annual pension = years of service x accrual rate x final average salary
An employee works for 30 years in a plan with an accrual rate of 1.5% and a final average salary of $80,000. Annual pension = 30 x 0.015 x $80,000. First, 30 x 0.015 = 0.45. Then 0.45 x $80,000 = $36,000 a year, which is 45% of final average salary.Case study
Seen in the real world.
Marrowfield Engineering is an illustrative, fictional company with an old defined benefit plan for 800 members. A fall in investment markets pushed the plan into a $12,000,000 deficit, and the lender raised questions at the next review.
The finance director agreed a recovery plan with the trustees, under which the company would add $2,000,000 a year for six years. She also closed the plan to new joiners and offered them a defined contribution plan instead.
Marrowfield is a made-up company, so the numbers are for teaching only. The lender accepted the plan because it turned an open-ended risk into a scheduled payment that the company could budget for. Trustees reviewed the funding position every three years and adjusted the schedule if conditions changed.
Watch out
Common mistakes.
- Assuming the employer's promise is risk free for members, when the plan's funding and the employer's strength both matter.
- Treating the pension deficit as an accounting entry only, when it often requires real cash contributions.
- Ignoring how sensitive the liability is to the discount rate and life expectancy assumptions.
Questions
People also ask.
How is it different from a defined contribution plan?
In a defined benefit plan the employer promises the income and bears the risk, while in a defined contribution plan the employee's pension depends on contributions and investment returns.
What is a pension deficit?
It is the amount by which the plan's liabilities exceed the value of its assets, and it is usually measured by actuaries using agreed assumptions.
Why have many companies closed these plans?
The cost and uncertainty are hard to manage, particularly as people live longer and investment returns vary.
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