A. How Defined Benefit Schemes Work
How Does a Defined Benefit Scheme Work?
Pay As You Go
Advance Funding
Tax Treatment
Other Features
A. HOW DOES A DEFINED BENEFIT SCHEME WORK?
An employer setting up a defined benefits scheme intends to promise the scheme members a specific amount of benefit to be paid on their retirement. In the old days, this benefit might have been a fixed amount of annual or weekly pension, or perhaps a set amount of pension for every year spent in the service of the employer. Later, the promised pension began to be defined as something based on pay and service combined, so the common pattern of defined benefits that we see today emerged. Modern defined benefit promises are usually expressed as a fraction or percentage of pay taken at or near retirement age, and multiplied by the completed service of the member.
A common formula nowadays would promise 1/60th of final pensionable pay for each year of pensionable service. This is usually intended to fix the maximum pension promised at 40/60, or two-thirds, of salary.
Because the benefit to be paid is fixed in this way, and because it is not possible to predict what the amount of final salary is going to be, it follows that we cannot know in advance what the promised benefit is going to cost.
For some employers this is not a problem. They simply pay their pensioners out of their current income and make no attempt to make any provision for them in advance of employees' retirement. Typically, this approach (called "pay as you go") is taken by Government, by local authorities and by some other public sector employers. Since the thinking behind this is that the Government cannot go bankrupt, it is possible for them to take this approach.
For most employers and their staff, however, this approach is not attractive. Employees are not happy with the idea that their security in retirement is going to depend on the employer being (a) still in existence and (b) making enough profit to pay their pensions. These employers put away money during their employees' working lives, to provide a fund from which the promised benefits can be paid in the future. Some of the money may be contributed by the members themselves. In that case, the rate of contribution is usually also defined. The employer then pays the balance of the cost. The recommended rate of payment is decided by an actuary, who makes various assumptions as to what will happen in the future to the members (how long they will live, survival by dependants and so on), their future rates of pay and the investment returns that the fund will be able to earn. These assumptions are reviewed from time to time in the light of actual experience and a new rate of contribution recommended, if appropriate.
Funding in advance for pensions is encouraged by the government, which gives favourable tax treatment to pension funds. This applies, not just to defined benefit schemes, but to defined contribution schemes as well. Both employers and scheme members receive tax relief on their contributions as they pay them. In addition, what the employer pays is not treated as employee earnings for tax purposes. Most important of all, the pension fund pays no tax on the investment income that it makes in the shape of dividend income and capital gains. In return, except for some limited benefits paid in cash on retirement or death, most of what is paid out as benefits from pension schemes is taxed under the PAYE system.
To qualify for this tax treatment, a scheme must be approved by the Revenue Commissioners, who police the maximum benefits that can be provided. It must be set up under a trust, which has the effect of legally separating the assets of the pension scheme from those of the employer.
Employee contributions are allowed, at the same rates as those mentioned below in the context of defined contribution schemes. It is usual for employees' mandatory contributions to be fixed as a percentage of their pensionable pay. The employer then pays the 'balance of cost' - the difference between the employees' total contributions and the contribution required to maintain the benefit promise.
The employer must make a "meaningful" contribution to the scheme. See the section on Defined Contribution Schemes.The test is applied to employer contributions on a lifetime basis in defined benefit schemes, whereas it must be met year by year in defined contribution schemes.
Apart from retirement pensions, defined benefit schemes usually include the option for the retiring employee to exchange some of his or her pension for a lump sum. Lump sum benefits for dependants on death are common features. Many schemes also provide pensions payable to spouses and/or other dependants.
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