DB Scheme

A DB Scheme, or Defined-Benefit Pension Scheme, promises a specified pension payment, lump-sum, or combination thereof on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service, and age.

What is a DB Scheme?

A DB Scheme (Defined-Benefit Pension Scheme) is a type of retirement plan where the employer commits to provide retirees with a specific, predetermined benefit based on factors such as salary history and duration of employment. The employer bears the investment risk and is responsible for providing the defined benefits irrespective of the fund’s performance.

Key Characteristics

  • Guarantee: Employees receive a guaranteed payout at retirement.
  • Calculation: Benefits are calculated using a predefined formula, often based on salary and years of service.
  • Employer Responsibility: The employer is responsible for ensuring the pension fund is adequately funded to meet future obligations.

Examples

  1. Example 1: Final Salary Plan

    • A company offers a final salary pension scheme where employees are entitled to receive an annual pension based on the average of their final five years of salary and their years of service.
    • An employee with a final average salary of $80,000 and 30 years of service might receive a pension of 1.5% of their salary for each year of service: 30 x 1.5% x $80,000 = $36,000 annually.
  2. Example 2: Career Average Plan

    • Another firm’s pension scheme might use a career-average formula.
    • An employee earning an average salary of $60,000 over their career with the same firm for 25 years might have a pension formula offering 1.2% of career average salary per year of service: 25 x 1.2% x $60,000 = $18,000 annually.

Frequently Asked Questions

Q: What is the main difference between a DB Scheme and a Defined-Contribution (DC) Scheme? A: In a DB Scheme, the employer guarantees a certain payout upon retirement, bearing the investment risk. In a DC Scheme, the contributions are defined, and the retirement benefit varies based on investment performance, with the employee typically bearing the investment risk.

Q: How does a DB Scheme manage investment risks? A: The employer manages the investments and absorbs the risks. They must ensure the pension fund is sufficiently funded to meet future obligations through ongoing contributions and effective investment strategies.

Q: Can an employee lose their benefits in a DB Scheme? A: Employees typically do not lose their benefits, given the employer’s obligation to fund the scheme. However, if an employer faces financial difficulties or bankruptcy, pension payments might be affected, potentially covered by pension insurance funds depending on legislation in the country.

Q: Is it possible to transfer pension rights in a DB Scheme? A: In some countries, employees can transfer accrued pension rights if they move to another employer with a comparable scheme, though this may result in adjustments to benefits.

Q: How are DB Scheme benefits taxed? A: Pension payments from a DB Scheme are generally taxed as income when they are received by the retiree, akin to regular earnings.

Defined Contribution (DC) Scheme: A retirement plan where the amount of the employer’s annual contribution is specified, but the future benefit varies based on investment returns.

Vesting: The process by which an employee accrues non-forfeitable rights over employer-provided pension benefits, ensuring they receive benefits when they leave the company after a minimum service period.

Pension Fund: The pool of funds collected from employer and employee contributions, invested to generate income and used to pay out pensions.

Actuary: A professional who assesses financial risks in the DB Scheme, determining the necessary contributions and funding strategies to ensure the plan’s solvency.

Online References

  1. Pension Benefit Guaranty Corporation (PBGC) - US government agency that protects the retirement incomes of more than 35 million American workers in private-sector defined benefit pension plans.
  2. The Pensions Regulator - UK regulator providing guidance for trustees, employers, and administrators of pension schemes.

Suggested Books

  • “Pension Mathematics with Numerical Illustrations” by Howard E. Winklevoss. A comprehensive guide on the mathematical foundations behind pension plans.
  • “Understanding Actuarial Practice” by Stuart A. Klugman, Harry H. Panjer, and Gordon E. Willmot. Essential for understanding the actuarial principles applied to pension schemes.
  • “The Handbook of Pension Mathematic” by Benjamin B. Rand. Offers insights into the mathematical models used for pension calculations.

Accounting Basics: “DB Scheme (Defined-Benefit Pension Scheme)” Fundamentals Quiz

### What mainly distinguishes a DB Scheme from a DC Scheme? - [ ] The level of employee contributions - [ ] The length of employment period - [x] The presence of a guaranteed payout - [ ] The requirement for life insurance alongside it > **Explanation:** A DB Scheme guarantees a specific payout at retirement, whereas a DC Scheme's benefits are based on investment performance and contributions. ### Who bears the investment risk in a DB Scheme? - [ ] The employee only - [ ] Both employer and employee equally - [x] The employer only - [ ] An independent third party > **Explanation:** The employer solely bears the investment risk in a DB Scheme. ### On what basis is a DB Scheme pension typically calculated? - [ ] Employee savings - [ ] Inflation rate - [x] Salary history and years of service - [ ] Current market conditions > **Explanation:** The pension amount in a DB Scheme is calculated based on an employee's salary history and years of service with the company. ### Which of these is a feature of a DB Scheme? - [ ] Variable contributions - [ ] Fixed retirement age - [x] Predefined retirement benefit - [ ] Market-dependent payouts > **Explanation:** DB Schemes provide predefined retirement benefits regardless of market conditions. ### What is “vesting” in the context of a DB Scheme? - [ ] Employer matching contributions - [x] Employee gaining non-forfeitable pension rights - [ ] Increasing benefits with service years - [ ] Profit-sharing among employees > **Explanation:** Vesting refers to the process by which employees gain non-forfeitable rights to their pension benefits. ### Can the retirement benefits in a DB Scheme be subject to tax? - [x] Yes, they are treated as regular income. - [ ] No, they are tax-free. - [ ] Only if they exceed a certain amount. - [ ] Only for non-employees. > **Explanation:** Retirement benefits from a DB Scheme are typically taxed as regular income. ### How can a DB Scheme benefit be transferred if an employee changes jobs? - [x] Via a pension transfer to a comparable scheme - [ ] As a cash payout subject to taxation - [ ] Transfer is not feasible - [ ] As a loan that needs repayment > **Explanation:** Pension benefits can be transferred to a comparable scheme when an employee changes employers in some jurisdictions, ensuring continued retirement savings. ### What qualifies an employee for DB Scheme benefits? - [ ] Holding company stocks - [x] Meeting the service period requirements - [ ] Contributing the maximum amount allowed - [ ] Completing specific job roles > **Explanation:** Employees usually qualify for DB Scheme benefits by fulfilling required minimum service periods. ### Why do companies maintain DB Schemes? - [ ] To boost their own financial statements - [ ] To avoid paying taxes - [x] To provide assured benefits and attract/retain employees - [ ] To follow a legal mandate > **Explanation:** DB Schemes are maintained to provide assured retirement benefits and to attract and retain employees. ### Which professional typically assesses financial risk in a DB Scheme? - [ ] Financial advisor - [ ] HR Manager - [x] Actuary - [ ] Accountant > **Explanation:** Actuaries assess the financial risks involved in maintaining a DB Scheme and aid in managing investment strategies.

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Tuesday, August 6, 2024

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