Previously in this series, I defined an occupational pension scheme as a retirement arrangement set up by an employer who contributes on behalf of workers for the provision of retirement benefits.
Most occupational schemes are classified as either a Defined Contribution (DC) or a Defined Benefit (DB) scheme. Having covered DC schemes in the last article, we now take a closer look at DB schemes.
Defined Benefit Pension Schemes
A DB Pension Scheme is a plan that promises the employee a defined amount of retirement income. Basically, the amount of benefit that the employee is entitled to in retirement is defined in advance.
In DC schemes, the retirement benefit of a member is determined by the size of the individual member’s account, influenced by the level of contributions (made by both the employer and the member) and the investment returns earned by the member’s funds.
We saw that the main drawback of this scheme was that it would be very difficult for a member to know in advance how much pension they will be able to secure at retirement and therefore plan accordingly.
On the other hand, DB Schemes allow members to know how much they will receive in retirement because the scheme promises to pay a certain amount at retirement. The employer is then responsible for making sure that there are enough funds to enable them to fulfil this promise.
The member’s benefit is typically determined by a specific formula linked to the member’s pensionable salary, the length of pensionable service with the employer and an accrual factor on earnings (all of which would be defined in the Scheme rules).
For example, your employer might provide a retirement benefit of 1 per cent of earnings for each year a member was in the scheme. If a member retired after 20 years, he would receive a pension of 20 per cent of their salary.
The salary used to calculate the retirement benefit may either be final salary (the level of salary at retirement or earlier exit) or career average salary (the average salary of the member during employment).
The benefit formula is laid out in the Trust Deed and Rules of the scheme. The Trust Deed and Rules is the legal document that spells out how the scheme is to be governed and defines the terms and conditions of the scheme.
The Board of Trustees is responsible for the governance of the scheme and must act within the rules of the scheme.
Contributions in a DB Scheme
A DB scheme can either be contributory, with both the member and the employer making contributions, or non-contributory with only the employer making contributions to the scheme to fund the member’s future benefits.
Like a DC Scheme, the contributions of the scheme are invested to generate investment income to help the scheme to meet its obligations. Unlike in a DC scheme, the level of returns achieved by the scheme has no direct bearing on the benefits to be paid to the member!
To explain this more clearly – If the scheme earns lower than expected returns, the employer will have to make additional contributions to provide the promised benefit.
Conversely, better than expected investment income means that the employer can reduce contributions to the scheme.
Funding of a Defined Benefit Pension Scheme
When you participate in a DB scheme, the scheme is making you a PROMISE: A promise to pay you a set amount of monthly income during your retirement, that will be calculated based on the scheme rules. Every year that you work, your promise increases and becomes closer to payment.
DB schemes can either be funded (where assets are set aside as the members are working and earning the promise), or unfunded (where no assets are set aside in advance and benefits are paid by the employer as and when they arise). Unfunded schemes are common in the public sector, whereas private sector DB schemes are funded.
An actuary is involved in the funding of a DB scheme. The actuary must calculate the estimated value of all the promises already made by the Scheme (using many assumptions on things like salary growth, investment returns and life expectancy, to name a few).
The estimated value of all the promises is compared to the value of assets in the DB scheme and this determines the financial health of the scheme.
The actuary would also estimate the cost of new promises being earned each year, to advice on the required amount that needs to be contributed each year to keep the scheme healthy.
In Kenya, registered retirement schemes MUST be funded. The Retirement Benefits Authority (RBA) requires DB schemes to meet a minimum level of funding and this ensures that member’s benefits are well protected and less dependent on the long-term health of the employer.
Remember that all registered schemes are set up under Trust; hence the scheme is a separate legal entity from the employer.
It is the responsibility of the Trustees to ensure that there are sufficient funds to provide the expected benefit promised to each member and meet the minimum funding requirements dictated by the regulator.
Changes in demographics, volatile interest rates and lower expected returns have caused employers to be more aware of the risks associated with DB schemes.
Together with the greater mobility in today’s workforce which has in some way made DC schemes more attractive to potential employees, it has driven a shift to DC Schemes around the world even though DB schemes are the best bet that a member may have at a good retirement.
Adil Suleman is Head of Actuarial Division at Zamara.