Defined Benefit Pension also known as a Final Salary Pension or Superannuation Scheme
A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum or combination thereof on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending directly on individual investment returns. Traditionally, many governmental and public entities, as well as a large number of corporations, provided defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.
These schemes have become rarer in recent years as the employer/sponsor’s have no indication of the eventual cost to them in providing the scheme. Further the company’s directors may be held liable for any shortfall in the pension scheme’s funding. For this reason many employers have moved away from offering DB schemes in order to limit their liability.
A defined benefit plan is 'defined' in the sense that the benefit formula is defined and known in advance. Conversely, for a "defined contribution retirement saving plan", the formula for computing the employer's and employee's contributions is defined and known in advance, but the benefit to be paid out is not known in advance.
The most common type of formula used is based on the employee's terminal earnings (final salary). Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker's career.
In the private sector, defined benefit plans are often funded exclusively by employer contributions. For very small companies with one owner and a handful of younger employees, the business owner generally receives a high percentage of the benefits. In the public sector, defined benefit plans usually require employee contributions.
Over time, these plans may face deficits or surpluses between the money currently in their plans and the total amount of their pension obligations. Contributions may be made by the employee, the employer, or both. In many defined benefit plans the employer bears the investment risk and can benefit from surpluses.