Defined-benefit pensions are plans where an employer or plan sponsor promises a specified pension amount upon an employee’s retirement. The pension is determined by a formula that is defined and known in advance, and usually based on the employee’s earning history, years of service and a multiplier. The formula typically does not change. Target benefit plans are exactly that – a target -- they provide a general sense of what the final pension amount will be. But that target can move if the pension plan does not perform well.
Most defined-benefit plans have indexation, to ensure retirees’ incomes keep up with inflation. Some plans provide full indexation based on, for example, the Consumer Price Index; other plans may provide a portion of indexing based on the Consumer Price Indexing. Some pension plans have an indexing formula based on average inflation over a set period of time. Target benefit plan indexing is typically conditional on positive plan performance. Further, some plans may have rules or limits on how much of the plan’s money can be used on indexing.
Defined-benefit plans have are currently facing a new element of risk – rising costs due to difficult markets and shifting demographics. Target benefit plans may eliminate some of this risk by providing flexibility in the benefits that are paid, and in thereby shifting the risk of making up for shortfalls from the employer to the employees and retirees.
In recent years, it has been difficult to accurately account for defined benefit plans’ performance and make projections on their sustainability. As a result, we’ve seen many companies and governments, particularly in the United States and Europe, run into serious difficulties. Ideally, accounting in target benefit plans is based on contributions made, which is similar in practice to defined-contribution plans – in effect, a “real time” projection of the health of the fund and the benefits that can be paid from it.