Pension Plans: a focus on Defined Benefit Pension Schemes

CHAPTER 1 Pension Schemes and Pension System Reform 1.1. Introduction A pension plan is financial contract between a pension provider and the members of the plan, established for the purpose of providing an income during members' retirement. Usually, it is tax exempt or subjected to a lighter tax regime. Moreover, pension plans may provide other types of benefit, such as life insurance, which are paid as lump-sum rather than income. In analysing a pension plan we need to identify who can subscribe to it. Indeed, there are 3 different types of pension plan or pillars: • First Pillar, national pension plan, which cover all the citizens of a State with public funds obtained from taxation. • Second Pillar, group member plans, which refer to a group of people who usually work for the same employer, in the same economic sector or who in the same occupation; • Third Pillar, single member plans which refer to private insurance contracts taken out by an individual saving for retirement. Pension plans may be funded or unfunded. In a funded plan the cost of pension benefits is met during the same members period of service before retirement. A company, for example, aims to have 100% of the money needed to cover current pensions and those accrued from past service that will be paid out in the future. Members accumulate a fund they will use when retire, fund that is likely to be invested in a diversified portfolio of assets to gain a return and increase their final pension. In an unfunded plan, the cost of pension benefits is supported by working members of the plan. Younger and active members pay for the pension benefits of the older and no longer working members. Unlike funded plans, there are no assets to be invested, since active members contributions are use to pay the benefits of non-active members. 1.2. Single-Member, Group Pension and State Pension Plans 1.2.1. First Pillar: State Pension Plans. In a State Pension Plan the State provides pension to the employee. In almost all the industrialised countries exists a State Pension Plan, but during the last years a change in this field has occured. Indeed, employees have been looking for complementary retirement income outside the state system, particularly in countries like U.K. and U.S.A. UK state pension schemes are financed on a Pay-As-You-Go basis within 2 sort of payment: • flat-rate pension, also known as basic-pension, linked to inflation • earning-related pension for employees who have participated in the State Earnings Related Pension Scheme State Pension Plans are unfunded DB plans and the contributions are paid by employees and their employers through the taxes applied on their salary and invested in risk free assets to gain a rate of return that likely is not sufficient to pay all pensions. State Plans have a big enemy: the demographic trend. More people are reaching older age than in the past and this means larger pension costs for the State. Tthe birthrate is also slowing down. That creates an obvious problem: more people who will live longer in retirement but less people who will pay the pension contribution costs. Certain countries are changing their 5