What is a Defined-Benefit Pension Scheme?
A defined-benefit pension scheme (DB scheme) is an occupational pension scheme in which the retirement benefits to be received by employees are specified by the plan’s rules. These benefits are generally calculated based on a formula that incorporates the employee’s years of service and salary levels. Companies fund these plans accordingly, ensuring that the predetermined benefits can be paid upon the employee’s retirement.
Examples
- Final Salary Scheme: A common type of DB scheme where the retirement benefit is calculated based on the employee’s salary at the time of retirement and the number of years they have worked for the company.
- Career Average Revalued Earnings (CARE) Scheme: An alternative type of DB scheme where the retirement benefits are based on the average of the employee’s earnings throughout their career, adjusted for inflation.
Frequently Asked Questions (FAQ)
Q1: How is a defined-benefit pension different from a defined-contribution pension?
A defined-benefit pension guarantees a specific payout at retirement, while a defined-contribution pension depends on the contributions made and the investment performance of those contributions.
Q2: Why are companies closing defined-benefit pension schemes?
Rising costs associated with funding these schemes have led many companies to close their existing DB schemes to new employees, who are then required to join defined-contribution pension schemes.
Q3: How are pension costs accounted for in defined-benefit pension schemes?
Pension costs are accounted for according to the regulations set out in Section 28 of the Financial Reporting Standard applicable in the UK and Republic of Ireland, and International Accounting Standard (IAS) 19 for Employee Benefits.
Q4: What are the main components of the pension formula in a DB scheme?
The main components typically include the employee’s years of service and their final or career-average salary.
Q5: Are the benefits from a defined-benefit pension scheme adjusted for inflation?
It depends on the specific scheme. Some DB pensions include provisions for inflation adjustment, while others may not.
- Final Salary Scheme: A type of defined-benefit pension plan where the retirement benefit is influenced by the employee’s salary at the time of retirement.
- Defined-Contribution Pension Scheme: A pension plan where the retirement benefits are based on the contributions made and the performance of the investments chosen.
- IAS 19: International Accounting Standard 19, which provides guidance on accounting for employee benefits, including post-employment benefits like pensions.
Online References
Suggested Books for Further Studies
- “Fundamentals of Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan - Provides comprehensive insights into finance, including pension schemes.
- “Accounting for Pensions: The New Challenges” by Richard Brealey and Stewart Myers - Focused on understanding the complexities of pension accounting.
- “Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control” by Nigel Hawkins - Explores managing defined-benefit pension plans intentionally.
Accounting Basics: “Defined-Benefit Pension Scheme” Fundamentals Quiz
### What is the primary characteristic of a defined-benefit pension scheme?
- [ ] Contributions determine the final amount.
- [x] The benefits are predetermined by a specific formula.
- [ ] Investments define the pension benefits.
- [ ] It guarantees the return of contributions.
> **Explanation:** In a defined-benefit pension scheme, retirement benefits are predetermined by a specific formula, often based on years of service and salary levels.
### How are retirement benefits typically calculated in a final salary scheme?
- [ ] Based on the average salary throughout the employee’s career.
- [x] Based on the salary at the time of retirement.
- [ ] Independent of the employee's salary.
- [ ] Using a fixed monetary amount.
> **Explanation:** In a final salary scheme, retirement benefits are usually based on the employee’s salary at the time of their retirement.
### Who primarily funds a defined-benefit pension scheme?
- [x] The employer.
- [ ] The employee alone.
- [ ] The government.
- [ ] Third-party investment firms.
> **Explanation:** Defined-benefit pension schemes are primarily funded by the employer who ensures that sufficient funds are available to pay the predetermined retirement benefits.
### Which regulation primarily governs pension cost accounting in the UK and Republic of Ireland?
- [ ] Section 18 of the Financial Reporting Standard.
- [x] Section 28 of the Financial Reporting Standard.
- [ ] IAS 10.
- [ ] Generally Accepted Accounting Principles (GAAP).
> **Explanation:** Pension cost accounting for defined-benefit schemes in the UK and Republic of Ireland is primarily governed by Section 28 of the Financial Reporting Standard.
### What is a key challenge in accounting for defined-benefit pension schemes?
- [ ] Simplified financial valuation.
- [x] Evaluating and projecting future financial obligations.
- [ ] Balancing contributions vs. investments.
- [ ] Ensuring employee contributions.
> **Explanation:** A key challenge in accounting for defined-benefit pension schemes is evaluating and projecting future financial obligations accurately.
### Why have many companies switched to defined-contribution schemes from defined-benefit ones?
- [ ] Defined-contribution schemes offer higher retirement benefits.
- [x] Rising costs associated with defined-benefit schemes.
- [ ] They are less regulated.
- [ ] Employees demand defined-contribution schemes.
> **Explanation:** Rising costs associated with funding defined-benefit pension schemes have led many companies to switch to defined-contribution schemes.
### What financial elements do defined-benefit pension formulas typically include?
- [ ] Employee contributions and investment returns.
- [ ] Employee's choice of investment funds.
- [x] Years of service and salary levels.
- [ ] Market-based interest rates.
> **Explanation:** Defined-benefit pension formulas typically include years of service and salary levels of the employee.
### How should companies account for defined-benefit pension schemes according to IAS?
- [ ] Similar to defined-contribution plans.
- [x] According to IAS 19.
- [ ] Using historical costs.
- [ ] Based on employee age.
> **Explanation:** Companies should account for defined-benefit pension schemes according to International Accounting Standard (IAS) 19, which provides guidelines for employee benefits.
### Can new employees typically join existing defined-benefit pension schemes?
- [ ] Always, without restrictions.
- [ ] Only below a certain age.
- [x] Often, they are required to join defined-contribution schemes.
- [ ] Only after five years of service.
> **Explanation:** Due to the rising costs, many companies have closed existing defined-benefit schemes to new employees, requiring them to join defined-contribution schemes instead.
### How do defined-benefit pension schemes benefit employees?
- [x] By providing predictable retirement income.
- [ ] By allowing them to choose their investments.
- [ ] By reducing current salary.
- [ ] By offering immediate tax benefits.
> **Explanation:** Defined-benefit pension schemes benefit employees by providing predictable retirement income based on predefined formulas.
Thank you for exploring the intricacies of defined-benefit pension schemes and testing your knowledge with our comprehensive quiz. Keep advancing your financial expertise!
