What it means
In a defined benefit plan, the employer promises a specific retirement income instead of simply contributing to an investment account. The unit benefit formula states exactly how that income is calculated.
Each year of service buys a unit of benefit, so the longer a person works, the larger the pension. There are two common versions.
A flat unit formula gives a fixed dollar amount per year of service, such as $50 a month for each year, while a percentage unit formula gives a percentage of pay for each year, such as 1.5% of final average salary. The pay measure may be the final year, the average of the last three or five years, or career average earnings.
The formula matters to finance teams because the plan's liabilities are built from it. Actuaries, who are specialists in the mathematics of risk and longevity, use the formula with assumptions about pay rises, staff turnover and life expectancy to estimate what the company owes.
The result is reported as the projected benefit obligation, and changes to the formula directly change that figure. Employees value the formula because it gives a clear link between service and income.
It also affects workforce behaviour, because a generous percentage rewards long careers, while a flat formula may suit hourly staff whose pay changes little. Some plans cap the number of years that count, so the benefit stops growing after a set point.
Many employers have closed or frozen defined benefit plans because they are costly and carry investment and longevity risk. A freeze usually means the formula stops adding new units while the benefits already earned are kept.
The unit benefit approach is also a building block in other designs, such as cash balance plans, which look different but can be converted to the same measure.
In practice
Real-world examples.
Example
A municipal transport authority pays a pension of 1.8% of final average pay for each year of service. A driver retiring after 30 years with a final average salary of $60,000 receives 1.8% x 30 x 60,000 = $32,400 a year.
Example
A manufacturing company has a union plan that pays $60 a month for each year of service. A machinist with 20 years receives 60 x 20 = $1,200 a month, with no link to her final pay.
Example
A finance director evaluates changing the percentage from 1.5% to 1.25% for new joiners. Actuaries estimate how much the projected obligation falls, so the board can weigh the savings against the effect on recruitment.
Formula
Calculation
Annual pension = benefit percentage x years of service x final average salary
Consider an employee with 25 years of service and a final average salary of $90,000, in a plan with a benefit percentage of 2% per year of service. The annual pension is 2% x 25 x 90,000. First, 2% x 25 = 50%, and 50% x 90,000 = $45,000 a year. That works out at $45,000 / 12 = $3,750 a month, which replaces half of the final average salary.Case study
Seen in the real world.
Oakmere Brewing is an illustrative, fictional company that had offered a defined benefit pension for forty years. The formula paid 2% of final salary for each year of service, and the plan had become the largest liability on its balance sheet.
The finance director asked the actuary to show how the obligation would change under three options. Keeping the formula unchanged would leave the liability at $48,000,000, lowering the percentage to 1.5% for future service would reduce it to about $41,000,000, and freezing the plan would cut growth entirely.
The board chose to keep benefits already earned and reduce the percentage for future service, after consulting staff. The illustrative result was a more predictable pension cost, and a clear explanation of how each year of work still added to retirement income.
Watch out
Common mistakes.
- Treating the formula as a cash payment now, when it is a promise of income paid in retirement for as long as the member lives.
- Using the wrong pay measure, because final salary, final average salary and career average pay can produce very different results.
- Assuming the formula alone sets the cost of the plan, when the employer's cost also depends on investment returns, pay growth and life expectancy.
Questions
People also ask.
What is the difference between a flat and a percentage unit formula?
A flat formula pays a fixed dollar amount per year of service, while a percentage formula pays a share of pay for each year, so the second rises with salary.
Does the formula apply to a defined contribution plan?
No, because defined contribution plans pay whatever the account balance supports, with no promised benefit formula.
Can the formula be changed?
Employers can usually change it for future service, but benefits already earned are normally protected by law and by the plan rules.
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