A DEFINED BENEFIT (DB) pension plan, in a way, is the opposite of a defined contribution (DC) pension plan. For a DB plan, the benefit to the employee of the plan is prescribed and can be calculated. This varies with the employee’s length of service, age and salary history.
On the other hand, for a DC plan, the contributions that must be made to the plan are prescribed but there is no certainty as to the benefits that will result.
The DB plan will also have prescribed contributions to be made to the plan by the employer. However, this contribution may vary over time. Usually, the employer commits to providing a certain percentage of the employee’s pensionable earnings on a monthly basis to the DB plan.
However, an actuarial evaluation is normally made of the status of the plan at regular intervals. One aspect of this evaluation is assessing the ability of the accumulated pension fund to pay the prescribed projected benefits to all the plan members.
For the DB plan, the employer is responsible for making the investment decisions and bears all the risks. To the extent that the accumulated pension fund is less than what is required to meet the defined members’ benefits, then the pension plan is in deficit and the employer is required to contribute the shortfall as an additional expense of providing this benefit to the employees.
Similarly, if the accumulated fund is more than what is required, then the pension plan is in surplus and the employer may withhold contributions for a suitable period, often called a contribution holiday. Employees, however, will normally continue their contributions to the fund at the prescribed rate if any.
If the pension plan is non-contributory, there is no requirement for the employee to provide any payments towards the plan. If it is contributory, then the employee is normally required to make a set percentage contribution to the plan along with the employer’s contribution.
The employee’s specified level of contribution does not normally change over the life of the plan. The main possible variation in the percentage contribution an employee may make to a DB plan depends on whether the plan is integrated with the National Insurance Scheme (NIS) provisions or not.
If the pension plan is not integrated with NIS, then there will be no variation in the contribution rate by employees. However, where the plan is integrated with NIS, then the percentage contribution to the plan by the employee on any amount at or below the NIS ceiling for insurable earnings is reduced. That allows for part of the resulting pension payment to be provided by the NIS.
For a DC plan, the employee bears all the investment risks; the employee is responsible for making the investment decisions for his allocated portion of the fund. When the employee leaves the plan, either for retirement or earlier, subject to the provisions for vesting, whatever is the total contribution made for that employee plus the accumulated investment return on the contribution will be attributable to that employee.
So, for a DC plan, the benefit to the employee depends on the investment return during the intervening period, which in turn depends on the investment understanding of the employee. The employee may make investment decisions that result in a range from an enhanced retirement payout through to a deeply diminished retirement fund.
The current trend for employers is to move away from DB plans more toward DC plans. This trend is driven mainly by new accounting standards which require the evaluation results of pension plans to be reflected in the income statement of the organisation.
Businesses are therefore striving to get away from reflecting the operations of the pension plan on their income statement. This would be achieved by implementing DC plans.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. Email: Louisefairsave@nationnews.com. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.
