Defined benefit pension plan

Defined benefit pension plan (DB plan) is a type of Pension plan in which the retirement benefit payable to a participant is determined according to a predetermined formula or benefit structure. The benefit may depend on factors such as salary, years of service, age at retirement, and other conditions specified by the plan.

Unlike a Defined contribution pension plan, a defined benefit plan generally specifies the retirement benefit rather than the amount of contributions allocated to an individual account. The plan sponsor is generally responsible for ensuring that sufficient resources are available to meet the promised benefits, subject to the applicable legal and funding framework.

Structure

A defined benefit pension plan generally involves:

a predetermined benefit formula;
contributions from the employer, employees, or both;
investment of pension assets;
actuarial valuation of future pension obligations;
funding requirements;
payment of retirement benefits.

A simplified pension benefit formula may be represented as:

$Annual Pension = Accrual Rate \times Years of Service \times Pensionable Salary$

The actual formula varies among pension plans and jurisdictions.

Benefit formula

The benefit formula determines the amount of pension payable to a participant.

Common factors include:

final or average salary;
years of pensionable service;
an accrual rate;
retirement age;
other plan-specific factors.

For example, a plan may provide a pension based on a percentage of pensionable salary for each year of qualifying service.

Funding

Defined benefit plans require sufficient resources to finance promised benefits.

Funding may come from:

employer contributions;
employee contributions;
investment income;
investment returns;
other permitted sources.

The amount of required contributions may change as the plan's assets, liabilities, investment performance, demographic assumptions, and other conditions change.

Pension liabilities

The future pension payments promised by a defined benefit plan constitute pension obligations that generally extend over many years.

The present value of these future obligations can be estimated using actuarial methods.

A simplified representation is:

$P V = \sum_{t = 1}^{n} \frac{C F_{t}}{(1 + r)^{t}}$

where:

PV = present value of future pension payments;
CF_t = expected pension cash flow in period t;
r = applicable discount rate;
n = number of periods.

Actual pension-liability calculations incorporate actuarial assumptions and may account for mortality, retirement patterns, salary growth, inflation, and other factors.

Funding ratio

The financial position of a defined benefit pension plan can be assessed using a funding ratio.

A simplified funding ratio is:

$Funding Ratio = \frac{Pension Plan Assets}{Present Value of Pension Obligations} \times 100 %$

A ratio below 100% generally indicates that measured plan assets are less than measured pension obligations under the assumptions used.

A ratio above 100% indicates that measured assets exceed the measured obligations.

The interpretation of funding ratios depends on the applicable accounting and actuarial framework.

Investment risk

In a traditional defined benefit arrangement, the plan sponsor generally bears significant investment risk.

If investment returns are lower than expected, the plan may require additional contributions or other funding measures to meet its obligations.

If investment returns exceed expectations, the funding position may improve.

Longevity risk

Longevity risk is the risk that beneficiaries live longer than anticipated, resulting in pension payments being required for a longer period.

Because defined benefit plans generally promise benefits for specified periods or for the participant's lifetime, unexpected increases in longevity can increase pension liabilities.

Interest-rate risk

Changes in interest rates can affect the measured value of pension liabilities and the value of fixed-income investments held by the pension fund.

A decline in relevant discount rates can increase the present value of future pension obligations, while an increase can reduce their measured present value, subject to the applicable valuation framework.

Asset-liability management can be used to manage differences between the interest-rate sensitivity of pension assets and liabilities.

Inflation risk

Inflation can affect defined benefit plans when pension benefits are indexed to inflation or when salary growth affects the benefit formula.

Plans may therefore consider inflation assumptions when estimating future liabilities and determining investment strategies.

Actuarial valuation

Actuarial valuation is used to estimate the present value of future pension obligations and assess the financial position of a defined benefit plan.

Actuarial calculations may consider:

participant age;
salary;
years of service;
retirement assumptions;
mortality;
employee turnover;
inflation;
discount rates;
expected investment returns.

The assumptions used can materially affect the measured value of pension obligations.

Asset-liability management

Asset-liability management is an important component of defined benefit pension management.

The investment portfolio can be structured to reflect the expected timing and characteristics of pension obligations.

Strategies may include:

duration management;
liability-driven investment;
fixed-income investments;
diversification;
inflation-sensitive investments;
liquidity management.

Liability-driven investment

Liability-driven investment (LDI) is an investment approach in which the pension portfolio is constructed with explicit consideration of the plan's future liabilities.

The objective is generally to manage the sensitivity of the plan's assets and liabilities to factors such as interest rates and inflation while maintaining appropriate return potential.

Risk management

Defined benefit pension plans may manage:

investment risk;
interest-rate risk;
inflation risk;
longevity risk;
liquidity risk;
funding risk;
operational risk.

Risk management may involve diversification, hedging, liability matching, stress testing, and adjustments to contribution or investment policies.

Defined benefit versus defined contribution

A defined benefit plan differs from a Defined contribution pension plan primarily in how retirement benefits are determined.

Feature	Defined benefit plan	Defined contribution plan
Retirement benefit	Determined according to a benefit formula	Generally depends on accumulated account assets
Contributions	May vary according to funding requirements	Generally specified according to the plan
Investment risk	Generally borne primarily by the plan sponsor	Generally borne primarily by the participant
Longevity risk	Generally borne primarily by the plan sponsor	Generally borne primarily by the participant
Funding requirements	Depend on the plan's obligations and funding position	Generally based on specified contributions

The precise allocation of risks varies according to plan design and applicable law.

Advantages

Defined benefit pension plans can provide participants with greater predictability regarding retirement income because benefits are determined according to a predefined formula.

They can also provide benefits that are linked to salary and years of service, depending on the plan design.

Limitations

Defined benefit plans can create significant long-term funding obligations for plan sponsors.

Potential challenges include:

investment risk;
longevity risk;
interest-rate risk;
inflation risk;
funding volatility;
actuarial uncertainty;
administrative complexity.

The financial position of a plan can change substantially as economic and demographic assumptions change.

Example

Suppose a pension plan provides an annual benefit equal to:

$1.5 % \times Years of Service \times Final Average Salary$

An employee with 30 years of qualifying service and a final average salary of US$100,000 would have a simplified annual pension of:

$0.015 \times 30 \times 100, 000 = 45, 000$

The resulting annual pension would therefore be US$45,000 under the simplified formula, before considering the plan's actual rules and any applicable adjustments.

Importance

Defined benefit pension plans are an important form of retirement arrangement in which the plan sponsor generally assumes significant responsibility for funding and managing the risks associated with promised retirement benefits. Their long-term obligations make actuarial valuation, funding, asset-liability management, investment strategy, and risk management central to their operation.