Defined Benefit Scheme

Hi

While going through the course notes of Chapter 5 - Benefits Overview and Providers of Benefits, I had a doubt that how would increased longevity after retirement affect or be a risk to the employer in case of a defined benefit scheme, as it is based on a pre-determined formula which is usually influenced by the number of years of service in sponsor company, age, salary at retirement. As this amount is fixed , there should be no change in the amount due to the longevity of the member after retirement.

Thanks in advance!

 

Hi,

IMHO, there's a subtle assumption you've made in your question. And that is, the benefit amount (arrived using a formula based on salary/service) is paid, as a lumpsum, at retirement. DB Pension works slightly differently.

Allow me to illustrate via a simplified example.

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In India, there's a Govt. pension scheme which says that an employee is eligible for 50% of his last drawn pay after retirement given twenty or more years of service in the govt. Note, pension is paid monthly and for life.

Say, Mr. Bean, a govt. employee retires at 58, after 28 years of glorious service, and starts drawing pension. His status changes from active to current pensioner. Now, while provisioning in the books of accounts, the actuary has made certain mortality assumptions wr.t. Mr. Bean and similar employees. {In a DB Pension valuation, mortality assumptions play a crucial role, because, apart from discounting, it is this assumption which contributes most to experience losses (or gains)}.

Mr. Bean, at 58, experiences an epiphany at a local meditation class he joined immediately after retiring. He cleans his diet, starts working out, does morning yoga and goes for evening walks. And due to these lifestyle changes, he lives longer than what the actuary assumes in the valuation. The longer he lives the higher the payout for the Govt. And similar to Mr. Bean, if a good chunk of the cohort lives longer, the Govt. is s-----d as it has to make payments for longer period than expected. Hence, the term longevity risk. {Note, pension is paid for life}.

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Concluding remarks
- Longevity risk is higher when pension is paid for life.
However, the risk varies if pension is paid for a certain period (say 15 years post retirement).
- Longevity is precisely the reason why extensive mortality investigations (read CMI) are carried out on a regular basis. This allowes valuers to keep revising their mortality assumptions to quantify and manage risk accordingly.
- From an employer's perspective, DB Pension is one of the most expensive benefits it can offer to its employees. Organizations which have peaked years ago, close their plans to new members as it is super-expensive to maintain a DB plan. Further, developed countries have minimum contribution requirements towards a DB plan. So, there's a cash cost to an employer every year. There are cases where an employer has had to borrow money from the market to meet the minimum contribution requirements of a DB plan.

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Hope this gives a clearer idea.

Best Regards.

 

Hi Aisha,
Bear in mind that for a defined benefits scheme the scheme rules define the benefits independently of the contributions payable, and benefits are not directly related to the investments of the scheme. You are right when you say that the benefit is based on a pre-determined formula which is usually influenced by the number of years of service in sponsor company, age, salary at retirement. However, the sponsor promises the benefits (have a look at the different underlined words and think of the costs!).

For a current pensioner, the liabilities is defined by the current level of pension * annuity payable in advance at age x.

You would agree that living longer, means more payment hence the liabilities increase. This is why for a DB plan the sponsor bears the experience risk (higher longevity/ lower investment return/higher expenses).

Does this help at all?