Defined Benefit Pension Plans

IFRS Definition: Post-employment benefit plans other than defined contribution plans. Defined Benefit Pension Plans

In a traditional defined benefit (DB) pension plan, workers accrue a promise of a regular monthly payment from the date of their retirement until their death, or, in some cases, until the death of their spouse. The promised life annuity (deferred) is commonly based on a formula linked to an employee’s wages or salary and years of tenure at the sponsoring firm. In a typical DB plan the member earns a unit of pension, usually expressed as a percentage of nominal earnings, for each year of credited service/participation. The DB pension may be indexed to inflation but in a number of countries such as the U.S. and Canada, this is uncommon in private sector pensions. Defined Benefit Pension Plans

Various measures are used for the earnings base; in Australia, the U.K., the U.S., and Canada, the most common is ‘final salary’ – generally the employee’s average earnings over a specified period of time prior to retirement or earnings during a specified period of highest earnings1. In final salary plans the expected benefit is generally designed to replace a pre-determined percentage of ‘final salary’ based on a specific employment tenure that is typically ranging from about 35 to 40 years. The replacement rate varies considerably across plans; the most generous DB plans are designed with a salary replacement ratio of between 60-70 percent of final salary. Defined Benefit Pension Plans

Employers are generally legally obligated to make the promised payments once they have accrued and have been vested; firms are under no obligation to pay benefits that might be expected but have yet to actually accrue. Under certain conditions, employers may also terminate pension plans2 in some countries (e.g., the U.S.) but prohibitive tax penalties typically persuade employers to transform the pension plan rather than terminating it. In other countries such as the U.K. and Canada, the DB plan text may prohibit the termination of the plan. In practice, a full plan termination is often difficult to implement outside of corporate insolvency, particularly in highly unionized industries where a DB pension plan is usually a negotiated benefit. A full plan termination is, therefore, the least common of the three types of DB plan closures generally available to plan sponsors. These are 1) a hard freeze or termination (no additional benefits will accrue to any current plan members from either additional tenure or increases in compensation); 2) a soft freeze (generally limits increases for current plan members in accrued benefits due to increases in tenure but may allow the definition of compensation to increase); or 3) a partial freeze (plan is frozen for some but not all members)3. The shift from DB to DC plans is, therefore, generally a gradual process incorporating a transition period in which the employer will offer two types of pension plans; a DB plan for existing employees and a DC plan for new hires. Defined Benefit Pension Plans

Employees in DB pension plans may face insolvency risk if the sponsoring firm declares bankruptcy at a time when the plan is less than fully funded. Solvency risk has been partially mitigated in some countries through the creation of a pension benefit guaranty agency such as the U.S. Pension Benefit Guaranty Corporation (PBGC)4, or more recently, the U.K. Pension Protection Fund. In the event of bankruptcy, these agencies will take over the responsibility for making some portion of the promised payments to retirees. In these types of arrangements, the risks assumed by the guaranty fund may ultimately be passed on to taxpayers. Defined Benefit Pension Plans

The traditional DB pension framework imposes different types of risk on employers and employees5. In a DB pension fund, the employer bears the risk of providing the employee with a pension benefit that, as noted earlier, is typically expressed as a specific replacement rate of pre-retirement gross earnings. The employer also bears market timing or temporal risk, in that DB plan assets may fall short of what is required to meet this obligation at the time of the employee’s retirement. Through the pooling of plan contributions across a number of employees, not all of whom will retire at the same time, the employer is able to manage market timing risk much better than an individual would be able to. In managing the overall financial risk associated with a DB pension plan the employer bears ‘investment’ risk, the risk that actual returns on the assets set aside to fund accrued pension benefits may fall short of expectations; this could force employers to raise contributions if poor asset returns leave their pension plans sufficiently underfunded.

Note that we use the term investment risk to encompass market, credit and other types of risk that might arise from investing plan assets. Employers can hedge market risk by investing in fixed income securities that match the duration or cash flows, of their accrued liabilities; and if they use highly-rated fixed income securities they can also limit credit risk. In practice, the majority of DB plans are heavily invested in publicly-traded equities (one-half to two-thirds of assets), accepting the exposure to market risk and the equity premium that serves as compensation to hold down expected pension contributions6. Employers also bear “longevity” risk because they are generally obligated to offer DB benefits as a deferred life annuity. Longevity risk is the risk that plan beneficiaries will live longer, on average, than originally expected, increasing the time period for paying the benefit.

Employees, on the other hand, typically bear the brunt of inflation risk, because private DB plans generally do not index benefit payments for post-retirement increases in the general price level7. While inflation risk can be substantial, perhaps the greatest source of risk in DB pensions is “accrual” or “portability” risk, which reflects the fact that benefits have traditionally been loaded toward long-tenured employment relationships. Defined Benefit Pension Plans

Since benefit payments (nominal) are often computed as the product of earnings and tenure (both of which tend to increase each year) the accrual pattern is nonlinear in dollar terms (and in present value), with much of the final benefit accruing in the final years before retirement8. Therefore, any changes affecting benefit payments that may occur toward the final years of work – including changes to the benefit formula, plan terminations, or an employment separation – can result in accrued benefits actually falling far short of a worker’s expectations. And, pension “shortfalls” are a risk not only for long-tenured workers – accrual risks are also caused by fairly lengthy vesting periods9 during which workers typically forfeit all of their DB benefits if their plan terminates or their relationship with the employer is severed. Defined Benefit Pension Plans

Unless the DB pension plan is portable , which is uncommon in private sector plans, the backloading of DB plan benefits is significant for employees who change employers during their working career. Blake (2003) estimated the accrual losses from DB pension schemes under various assumptions. He found that a typical U.K. Worker who changed jobs at the average level of 6 times during their working career would suffer a loss of 25-30 percent of the full service benefit they would have received had they remained with the same employer throughout their career.

Accrual risk is less of an issue in multi-employer plans where the pension plan is generally portable across the employers belonging to the plan. In the Netherlands , for example, the majority of employer pension plans, apart from those of some of the largest firms, are industry-based.  Defined Benefit Pension Plans

The distribution of risks for employers (ultimately the shareholders in private sector plans) and employees in DB pension plans are summarized in Table 1. Generally, the employer bears all the investment risks related to investing in DB plan assets and funding shortfalls that arise for various reasons. DB pension plans are not without risk to employees, who typically bear inflation risk, vesting risk and the risk that the actual benefit received falls short of the expected salary replacement level at retirement. Outside of industry or multi-employer DB plans, accrual risk is high for employees who do not remain with the same employer throughout their working career. Defined Benefit Pension Plans

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