Guide to Analysing Companies

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01 Essential Finance 10/11/06 2:21 PM Page 100

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Defined benefit pension
A pension that promises to pay a specified amount to each
beneficiary after a set number of years of service. Also known
as a final-salary scheme because the benefit in retirement is a
proportion of the employee’s final salary when he or she
retires. Either the employer or the employee can contribute to
such pensions (usually it is both) but, importantly, the invest-
ment risk lies with the employer. So, whatever happens, the
retiree when eligible is guaranteed a minimum pension. This is
fine while stockmarkets are rising and surpluses are accu-
mulating to the pension scheme; it is not so fine for the
company when markets are falling and deficits are piling up.
Regulations forcing companies to reflect in their accounts any
shortfall in the funding level of their pension scheme, and to
make it up if necessary, have put extra pressure on such
schemes, particularly in the UK. The result is that many are
being closed to new entrants who instead are being offered
defined contribution pensions.
Defined contribution pension
A pension in which an employee elects to contribute a pro-
portion of his or her salary until retirement. In most cases an
employer will make contributions too, but, unlike a defined
benefit pension, the investment risk lies entirely with the em-
ployee. So the employer bears no responsibility for making up
any shortfall. Called 401(k) plans in the United States, where
they were started, defined contribution pensions are designed to
shift to the employee not just the investment risk (that is,
whether the scheme makes or loses money) but also responsi-
bility for managing it. The cost of administering pensions and
the unpredictability of the stockmarket have persuaded an
increasing number of countries and companies to opt for
defined contribution pensions. Japan, with one of the world’s
fastest-ageing populations, and countries in continental Europe
are embracing the idea.