DB Schemes allow members to know how much they will receive in retirement. FILE PHOTO | NMG
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.
Retirement Benefits
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.
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