What is a ‘defined benefit’ or ‘final salary’ pension? Investing Explained

In this series, we break through the jargon and explain a popular investment term or theme. Here it is ‘defined benefit’.

DB? David Beckham?

Nothing so glamorous. It stands for ‘defined benefit’, a form of pension.

DB plans are also referred to as “final pay,” the traditional form of occupational retirement plans, based on the employee’s years of service and, as the name suggests, the pay at the end of the career. Sometimes, to further cloud the waters, the payout is tied to an employee’s average salary over an employee’s career, not their latest pay package. Britain has some 5,000 DB schemes, often described as ‘gold-plated’ because of the guaranteed and generous pensions.

What is a DC plan?

‘Defined Contribution’, also known as ‘money purchase’. With this type of company pension, what you receive on retirement is based on the value of the pot built up from your contributions and that of your employer over the course of your career. These are invested in stocks and other assets.

Where can I get a DB plan?

Only a few employees now have access to a DB plan. Most private sector schemes are closed to new members. About 79 percent of employees contribute to a company pension, but only 8 percent of these are members of the DB plan. Companies found that they could no longer afford to keep DB plans open. They are good for employees, but come with high risks and costs for employers. However, millions are members of existing schemes, which either receive a pension or are entitled to a future pension income.

Have DB schemes been in the news?

Probably more in recent weeks than in their entire history. Crisis hit the DB sector in the wake of the mini-Budget of former Chancellor Kwasi Kwarteng. Many DB funds have invested through complex liability-driven investment schemes (LDI), which aim to increase returns but have been nearly imploded by rising interest rates.

What happened?

LDIs try to match liabilities in part by investing in government bonds (gilt-edged government bonds), against which they borrow or leverage to buy even more government bonds or other assets. When Kwarteng’s measures torpedoed gold prices and soared yields, funds were forced to sell in response to calls from their lenders for more collateral.

To prevent the collapse of some funds – which were ‘hours of disaster’ – the Bank of England intervened.

Should I be concerned about my schedule?

The dangers of LDIs do not appear to be widely recognized. But the Bank of England is working with the Financial Conduct Authority watchdog and the pension regulator to ‘ensure stricter standards are put in place’.

Nothing is simple in the pension viewing world and the jump in gold yields has improved the funding position of DB plans as it has lowered the bill for paying income to retired participants. If a fund gets into difficulties, the employer has to intervene and as a last resort there is also a Pension Protection Scheme that partially indemnifies the participants’ nest eggs.

And the prospects for DB schemes?

More companies may be inclined to do “buy-out” deals, transferring their retirement promises to an insurance company, which takes over the obligations.