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What is a ‘defined benefit’ or ‘final salary’ pension? Investing Explained

INVESTING EXPLAINED: What you need to know about ‘defined benefit’, a type of pension – sometimes known as ‘final salary’

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s ‘defined benefit’. 

DB? David Beckham? 

Nothing so glamorous. It stands for ‘defined benefit’, a type of pension. 

DB schemes are sometimes known as ‘final salary’, the traditional kind of company pension scheme, based on the employee’s years of service and, as the name suggests, their pay at their career’s end. Sometimes, to muddy the waters further, the payout is linked to average salary over an employee’s career, not their final pay packet. Britain has 5,000 or so DB schemes, often described as ‘gold-plated’ because of the guaranteed and generous pensions provided. 

Money in the bank: DB schemes are sometimes known as ‘final salary’, the traditional kind of company pension scheme

What is a DC scheme? 

‘Defined contribution’, also known as ‘money-purchase’. With this type of company pension, what you receive on retirement is based on the value of the pot built up from your contributions and those made by your employer over the course of your career. These are invested in shares and other assets. 

Where can I get a DB scheme? 

Only a few workers now have access to a DB scheme. Most private sector schemes are closed to new members. About 79 per cent of employees contribute to a company pension, but just 8 per cent of these are DB scheme members. Firms found they could no longer afford to keep DB schemes open. They are good for employees, but involved high risks and costs for employers. However, millions are members of existing schemes, either receiving a pension or having entitlements to a future retirement income. 

Have DB schemes been in the news? 

Probably more so in the last few weeks than in their entire history. Crisis hit the DB sector in the wake of former chancellor Kwasi Kwarteng’s mini-Budget. Many DB funds have invested via complex liability-driven investment (LDI) schemes, which aim to boost returns, but almost imploded due to rising interest rates. 

What happened? 

LDIs try to match liabilities partly by investing in gilts (government gilt-edged bonds), against which they borrow or ‘leverage’ to buy yet more gilts or other assets. When the Kwarteng measures torpedoed gilt prices, and sent yields soaring, funds were compelled to sell to meet calls from their lenders for more collateral.

To avert the collapse of some funds – which were ‘hours from disaster’ – the Bank of England stepped in. 

Should I worry about my scheme? 

The dangers of LDIs seem not to have been widely recognised. But the Bank of England is working with the Financial Conduct Authority watchdog and the Pensions Regulator to ‘ensure strengthened standards are put in place’. 

In the looking glass world of pensions, nothing is simple and the leap in gilt yields has improved the funding position of DB schemes, as it has reduced the bill for paying incomes to retired members. If a fund is in difficulty, the employer has to step in and, as a last resort, there is also a Pension Protection Scheme that will partially safeguard members’ nest-eggs. 

And the outlook for DB schemes? 

More companies may be minded to do ‘buyout’ deals, under which they transfer their pension promises to an insurance company, which assumes the liabilities.

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Read more at DailyMail.co.uk