What it means
There are two main families of pension plan. A defined benefit plan promises a specified income in retirement, usually calculated from years of service and salary, and the employer is responsible for funding whatever it costs to deliver that promise.
A defined contribution plan instead specifies what goes in, and the retirement income depends entirely on how the invested pot performs. The distinction matters enormously for a business.
A defined benefit promise creates a long-term liability that sits on the balance sheet and moves with interest rates, life expectancy and investment returns, none of which the employer controls. A defined contribution plan converts that open-ended obligation into a predictable annual cost.
For employees the risk sits on the opposite side. Under a defined benefit plan the income is known and the employer absorbs the market risk, whereas under a defined contribution plan the individual bears the consequences of poor returns or retiring in a bad year for markets.
Most countries now require employers to offer some form of workplace pension and to contribute a minimum percentage of pay, with employees joining automatically unless they opt out. Contributions typically receive tax relief on the way in, and the resulting income is taxed on the way out, which is why pensions are usually the most tax-efficient long-term saving available to an employee.
The nuance that catches managers out is funding status. A defined benefit plan is described as fully funded, in surplus or in deficit depending on whether its assets cover the present value of its promises, and a deficit can force cash contributions that compete directly with investment in the business.
In practice
Real-world examples.
Example
A manufacturing group closes its defined benefit plan to new joiners and moves everyone hired after that date onto a defined contribution plan with a 7% employer contribution. The finance director explains to the board that this caps future liabilities but does nothing about the $18,000,000 deficit already sitting in the closed plan.
Example
A marketing agency with 40 staff enrols everyone automatically into a workplace pension, contributing 5% of salary against employee contributions of 4%. Two employees opt out, and the agency keeps written records of the opt-outs because the regulator requires evidence that nobody was encouraged to leave.
Example
A finance business is buying a small competitor and discovers a legacy defined benefit plan among the target's liabilities. The acquirer reduces its offer by the estimated cost of funding the plan and insists on an actuarial valuation before the deal completes.
Think of it
“Pension plan is employer retirement benefit-income or savings for retirement.
Formula
Calculation
Annual Defined Benefit Pension = Years of Service x Accrual Rate x Pensionable Salary
An employee retires after 30 years of service under a plan with an accrual rate of 1.5% and a final pensionable salary of $72,000. The annual pension is 30 x 1.5% x $72,000. Working it through, 30 x 1.5% = 45%, and 45% of $72,000 = $32,400 a year for life, usually with some increase each year to reflect inflation.
Compare that with a defined contribution arrangement where the employer pays 8% of the same $72,000 salary, which is $5,760 a year into an investment pot. Nothing about the eventual income is promised: the retirement income depends on how much the pot has grown and what it can buy in the form of an annuity or a drawdown plan when the employee stops working.Case study
Seen in the real world.
Ashcombe Engineering is a fictional mid-sized manufacturer used here as an illustrative case. It operated a defined benefit plan for 40 years and had always described it as comfortably funded, because the plan's assets exceeded its liabilities on the measure it had historically used.
A period of falling interest rates changed the picture sharply. Lower rates raise the present value of future pension promises, and although the plan's investments performed reasonably, the liabilities grew faster, turning a small surplus into a deficit of $22,000,000. Ashcombe was required to agree a recovery plan with the trustees, committing $2,750,000 a year for eight years.
That cash commitment arrived at the same time as a planned factory upgrade, and in this illustrative story the upgrade was postponed by three years. The board's reflection was that the pension promise had been treated as a human resources matter for decades when it was, in substance, one of the company's largest and most volatile financial obligations.
Watch out
Common mistakes.
- Treating a pension contribution as an optional employee benefit rather than a legal obligation with penalties for non-compliance.
- Assuming a defined benefit plan that shows a surplus one year is permanently safe, when the funding position moves with interest rates and life expectancy.
- Confusing the size of a defined contribution pot with a guaranteed income, when the income depends on how the pot is converted at retirement.
Questions
People also ask.
Who bears the investment risk in each type of plan?
The employer bears it under a defined benefit plan, while the individual bears it under a defined contribution plan.
Why do pension liabilities move so much with interest rates?
Because the liability is the present value of payments stretching decades ahead, and a lower discount rate makes those distant payments worth more in today's money.
Can an employee have more than one pension plan?
Yes, most people accumulate several across different employers, and they can usually be left where they are or consolidated, subject to checking any guarantees that would be lost.
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