Defined-Benefit Pension Scheme

A Defined-Benefit Pension Scheme (also known as a 'Defined-Benefit Plan' or, more colloquially in places like the UK, a 'Final Salary Scheme') is a type of pension plan in which an employer promises a specified, guaranteed income to an employee upon retirement. Think of it as a retirement paycheck for life. The “defined-benefit” is the key feature: the amount you receive is fixed by a formula, not by the ups and downs of the stock market. This formula typically considers factors like your salary history, age, and the number of years you worked for the company. Crucially, under this model, the employer bears all the investment risk. The company is responsible for contributing to a pension fund and managing its investments to ensure it can meet its future promises to retirees. If the fund’s investments perform poorly, the company—not the employee—is on the hook to make up the difference. This stands in stark contrast to its modern cousin, the defined-contribution pension scheme, where the employee's retirement outcome depends entirely on their own contributions and investment success.

The magic of a defined-benefit (DB) scheme lies in its predictable formula. While the exact calculation varies, a common structure looks something like this: (Years of Service) x (Final Salary) x (Accrual Rate) The Accrual Rate is the percentage of your salary you earn in pension benefits each year, often something like 1/60th or 1.5%.

Let's imagine Sarah works for a company for 30 years and her final salary is €60,000. Her company's DB scheme has an accrual rate of 1.5% (or 1/66.7).

• Her annual pension would be: 30 years x €60,000 x 1.5% = €27,000 per year.

Sarah can now plan her retirement with the certainty of receiving €27,000 every year for the rest of her life, adjusted for inflation or not, depending on the scheme's rules. For the company, this “pension promise” is a massive long-term liability recorded on its balance sheet.

Understanding the difference between these two pension types is critical for any investor or employee planning for the future. The core distinction is simple: Who takes the risk?

• Defined-Benefit (DB) Scheme
  1. Benefit: A predictable, guaranteed income for life. You know what you're getting.
  2. Risk: Borne entirely by the employer. If investments tank, the company must find the cash to fill the gap.
  3. Control: The employee has zero control over how the pension fund's assets are invested.
• Defined-Contribution (DC) Scheme (e.g., a 401(k) in the US or a SIPP in the UK)
  1. Benefit: Unknown and variable. It depends entirely on how much was contributed and how well the investments performed.
  2. Risk: Borne entirely by the employee. A market crash just before retirement can be devastating.
  3. Control: The employee chooses their own investments from a menu of options provided by the plan administrator.

For employees, a DB scheme is a golden ticket. For the companies that offer them, they have become a financial headache, which is why they have become increasingly rare in the private sector. From a value investing perspective, analysing a company's pension obligations is non-negotiable. Here’s why they've fallen out of favour:

• Longevity Risk: People are living much longer than they used to. A promise made in the 1980s based on shorter life expectancies might now mean paying a pension for 30+ years instead of the anticipated 15, dramatically increasing the total cost.
• Investment & Interest Rate Risk: Companies must invest the pension fund's assets to grow enough to cover future payments. A severe market downturn (like the 2008 financial crisis) can create a colossal pension deficit—a shortfall between the assets in the fund and the promised benefits. Furthermore, low interest rates are a killer. Accountants use current interest rates for discounting future cash flows, so when rates fall, the present-day value of those future pension promises balloons, making the deficit look even larger.
• A Claim on Earnings: As the great investor Warren Buffett has pointed out, a large, underfunded pension plan acts like a giant, invisible debt. It's a first claim on a company's future earnings, competing directly with shareholders for cash that could otherwise be used for dividends, share buybacks, or reinvestment in the business.

• If you are lucky enough to have a DB pension: Treasure it. This is a highly valuable asset, equivalent to owning a portfolio of high-quality bonds or a government-backed annuity. It provides a solid, reliable income floor for your retirement, which may allow you to take on more calculated risk with your other personal investments.
• If you are investing in a company with a DB scheme: Be a detective. Dig into the notes of the annual report and find the pension section. Look for the scheme's funding status (is it in surplus or deficit?) and the assumptions the company is using for investment returns and employee longevity. A company saddled with a massive, underfunded pension plan may have its financial flexibility severely constrained for years to come, making it a less attractive investment.