Pensions are an important part of an employee’s financial future, and a key area of work for actuaries. One of the main differences between pension arrangements is who bears the risk if there is not enough money to provide the expected benefits. Two important types are and pensions. In it is the employer who bears the risk; in it is you. The rest of this course follows from that answer.
This lesson takes the first half of the answer: the (DB) promise.
A pension set by formula
A DB () scheme promises a pension for life, and the size of that pension is set by a formula agreed in advance:
pension = × × salary measure
The classic example is a "1/60th " scheme. Each year you work () earns you 1/60th (the ) of your salary at or near retirement (the salary measure). Work 30 years and retire on 30/60, half your , every year for the rest of your life.
Concretely: 30 years of service and a of £45,000 gives 30/60 × £45,000 = £22,500 a year. Some schemes use 1/80th accrual instead (the same 30 years and £45,000 would give 30/80 × £45,000 = £16,875), often alongside a separate lump sum.
What the formula does not tell you is when. It gives the pension payable from the scheme's ; take it earlier or later and the amount changes, by factors that come later in the course.
The formula says nothing about investment returns, life expectancy or what markets did the year you retired. The member's pension is set by service and salary, then increased as legislation and the scheme's rules require. Funding it is the employer's job. Running the scheme is a separate job: the assets sit in a , held apart from the employer's business by a board of trustees whose duty is to the members.
Three risks the sponsor carries
The employer (the ) stands behind the promise, which means the sponsor bears three risks that make pensions actuarially interesting:
- . The scheme's fund is invested. If returns disappoint, the member's pension doesn't shrink; the scheme's funding position does, and closing that gap is the 's problem.
- . DB benefits are typically to a degree set by legislation and scheme rules, and those increases are usually capped, commonly at 5% or 2.5% a year. When inflation jumps, the promise gets more expensive up to that cap and the absorbs the extra cost. Above the cap the increase stops short of the index, and that shortfall is the member's.
- . The pension is payable for life. If pensioners live longer than assumed, the payments simply keep coming, at the 's expense.
An employer running a DB scheme has, in effect, written every member an income for life and taken the other side of the bet on markets and mortality. Over time, improving life expectancy made DB promises more expensive than many schemes had previously expected. If members live longer, the scheme has to pay their pensions for more years, and those payments may also increase with inflation.
There is no pot with your name on it
A DB scheme does not keep a pot for each member. There is one collective fund, invested as a whole, backing all of the promises at once. Your pension is paid from the same fund as everyone else's.
So what is your DB pension "worth"? An actuary can estimate what the promise is expected to cost the fund, but that number is a valuation of a promise, not an account balance. Nothing is earmarked, nothing sits in your name, and the estimate moves when the assumptions behind it move. Individual pots exist in schemes (the next lesson).
Final salary vs CARE
Two salary measures dominate:
| What differs | Final salary | CARE |
|---|---|---|
| Salary in the formula | Pay at or near retirement | Each year's pay, revalued to retirement |
| A big promotion at 55 | Uplifts every past year of accrual | Uplifts future accrual only |
| Predictability for the | Lower: salary growth is a risk to the end | Higher: each year's promise is banked as you go |
upgrades your entire service history every time your pay rises: 30 years of accrual, all priced at your pay at or near retirement.
CARE, , banks a slice of pension each year based on that year's salary, then revalues each banked slice (typically in line with inflation) between then and retirement. Earn £30,000 this year in a 1/60th scheme and you bank £500 a year of future pension, revalued from now until you draw it.
The price is a different lesson
You can now turn service and salary into a promised income. What you cannot yet do is say what that promise costs today. A stream of payments starting in twenty years and running for thirty more has no obvious price tag. Putting one on it is where module 2 begins.
Three checks on the promise before the price:
Check your understanding
Priya and Sam have each built up 27 years in a 1/60th arrangement and each is handed a £6,000 rise twelve months before they retire. Priya sits in a final-salary section, set on pay in her last year; Sam sits in a CARE section. How much extra annual pension does that rise buy each of them?
A DB member asks how much is in her pension pot. The accurate answer is that...
A scheme increases pensions in payment in line with CPI, capped at 2.5% a year. CPI for the year comes in at 5%. By how much does the pension increase?
Now try the formula yourself:
Work it out
A member of a 1/60th final-salary scheme retires after 24 years' pensionable service on a final salary of £52,000. What annual pension has she earned?