Pensions provide employees with a retirement source of income. A pension may be earned through a Defined Benefit Plan (DB Plan), a Defined Contribution Plan (DC Plan) or a Shared Risk Plan (SRP).
Defined Benefit Plan
A DB plan can be contributory (employees and employers make contributions) or non-contributory (only the employer contributes). A formula determines the benefits paid at retirement, not the performance of the money invested in the plan. The formula takes into account the employee’s earnings, years of employment, age and other factors. In a defined-benefit plan, the employer or plan sponsor assumes all the investment risk and portfolio management responsibility.
Defined Contribution Plan
In a DC plan, the employer or both employer and employee make fixed contributions which are invested on the employees’ behalf. The final benefits each employee will receive depend on the level of contributions each employee makes and the performance of the money invested in the plan (for example, the interest earned on contributions). In a defined-contribution plan each employee or retiree assumes the investment risk and longevity risk (the potential to outlive your pension income), not the employer or plan sponsor. Investment choices and portfolio management are also often the employee’s responsibility.
Shared Risk Plan
The SRP is a type of target benefit plan with mandated risk management principles. The key characteristics of an SRP are:
- fixed contributions (or variable only within a narrow, pre-determined margin),
- targeted benefit at retirement,
- the ability to reduce benefits if necessary to balance the plan’s funding, and
- mandated risk management principles to help ensure the targeted benefits can be provided in the vast majority of economic scenarios.
There are two types of benefits under an SRP: base benefits and ancillary benefits.
- Base Benefits must be funded so that there is a 97.5% probability that they will not be reduced over a 20-year period.
- Ancillary benefits must be funded so that, on average, at least 75% of their targeted value will be paid over the same 20-year period. Contributions into the SRP are set at a level that will allow the plan to pay for the projected benefits and meet the risk management tests.
Under the SRP, generally both employers and employees contribute to the plan. Employee contributions cannot be more than half of the total amount of contributions.
The financial state of the plan must be reviewed each year. If necessary, predefined actions must be taken. An SRP is governed by a funding policy that may allow or require changes to contributions in certain circumstances. The funding policy lays out the steps to take and their order of priority, in order to deal with funding deficits and funding surpluses that may develop.