Pension (DB vs BC)

I don't have any pension background at all. I hope someone can explain it in more detail. Thank you!

From Acted Notes: "
Defined benefit schemes
The cost of providing all of the benefits is not known with certainty until all the benefit payments have been made. There may be some flexibility as to when the money is set aside to pay for members’ benefits. At one end of the scale, no money may be set aside in advance and the money found just as each benefit payment is made – this means the scheme is unfunded and the benefits are being financed on a pay-as-you-go basis. This is how the Basic State pension works in the UK. Alternatively, the scheme may be funded – this means money is set aside before the benefit payments are made and investment returns can be earned on this money. Most occupational schemes are funded.

Defined contribution schemes
Money is almost always set aside gradually over the member’s working lifetime. The timing of when money is paid into the scheme is key, since the money needs to be invested at the right time to earn the investment returns that will provide an adequate pension."

From my understanding, for DB scheme, amount that the members will receive in retirement depends on final 3 years average salary, and the calculation is known.
For example, annual salary for first 20 years is £20,000. annual salary for last 10 years is £30,000.
years of service = 30 years, last 3 average salary = £30,000, final factor = 1.5%
So, member will receive = 30 * £30,000 * 1.5% = £135,000 (Please correct me if I'm wrong)

So, my questions are:
1. The cost of providing all of the benefits is not known with certainty until all the benefit payments have been made. --> Why cost is unknown until all benefit payments have been made? We have the all details of salary, services years, factor, we know the cost to pay is £135,000

2. scheme is unfunded and the benefits are being financed on a pay-as-you-go basis --> The 'pay as you go' means pension company will find money to pay when members claim their benefits? Why do they do this as this is very risky?

3. Does funded simply means set money aside and unfunded means no set money aside?

4. The timing of when money is paid into the scheme is key, since the money needs to be invested at the right time --> The timing is fix isn't it? Like the payment made by members are annually. Else, can give me a simple example on this?

Thank you

 

Hi I’ll my best to answer, but happy to hear thoughts from other persons.
1) yes you can calculate the annual pension amount for a member at retirement. However I think by “cost” the notes is referring to the amount that will be paid throughout a person’s lifetime. You will never know with 100% accuracy how long pensioners will survive and thus how much you will pay. You will only know when the last payment is made, ie when last person dies. You don’t know if all active employees will survive/remain in service until retirement. If pension is linked to RPI, you won’t know in advance exactly how much will be paid over time. Altogether, there are plenty unknowns so the cost in uncertain.
2)agree it is risky. I think answers to this have given handy 0.5 mark points in past exam papers. I can’t remember all the reasons off-hand but some reasons are: opportunity cost (company thinks it can better benefit by putting its money/capital elsewhere); plan may have small membership so the PAYG isn’t too onerous; company is profitable and can easily afford payments when needed; poor understanding by company of the long-term costs of PAYG; poor regulations; no legislative requirement to fund DB schemes; no suitable local investments to build a fund, so prefer to invest in company.
PAYG is usually done by the State.
3) I want to say yes, in broad terms. I can’t remember if book reserving is considered in the notes as funded/unfunded; or if that was in CP1 at all.
4) My interpretation of the notes is that ideally you invest at the “best time”, eg buy at lowest price and sell at highest. Yes, money is paid into scheme at set times, eg monthly/annually. Ideally these set times will be at the “best time”. Or notes may also mean you put enough money into the fund, maybe as cash, so that when a good investment opportunity arises (which may not be exactly when money is put into fund), the scheme has enough liquid assets available to maximize on the investment.
Hope the above is helpful, and that other persons chime in with their own answers.

 

Thank you both