Defined Benefit (DB) scheme

In a Defined Benefit scheme, the pension is promised up front. The retiree knows exactly what they will receive — it is usually tied to their final salary and years of service, not to how any investment performed.

That certainty comes at a price for whoever is paying the pension. If the money set aside does not earn enough, or if people live longer than expected, the gap has to be made up from somewhere else.

In a defined benefit plan, the pension amount or value of retirement benefit is known beforehand and is generally a function of last drawn salary and the period of employment.

DB schemes are either funded or unfunded. In a funded DB scheme, the employer or a trustee sets aside contributions during the employee's working life into a dedicated, invested corpus, which is then used to pay the promised pension. In an unfunded, or pay-as-you-go, DB scheme, no separate corpus is built up in advance — pensions to today's retirees are paid directly out of the employer's current revenue or budget.

The clearest Indian example of an unfunded DB scheme is the Old Pension Scheme (OPS), which applied to Central and State Government employees who joined service before 1 January 2004: a pension equal to 50% of last drawn salary (plus dearness relief) was paid each year out of the government's budget, with no dedicated investment corpus behind it.

By the late 1990s this had become a serious fiscal concern, as pension outgo rose faster than revenue. A government committee under S.A. Dave, set up in 1998, reported in 2000 as the Project OASIS Report, and recommended moving away from unfunded DB promises toward a funded, defined-contribution architecture with individual portable accounts — the intellectual root of what became the NPS.

Mr Menon joined the State Government service in 1995, before the 1 January 2004 cut-off, so he is covered under the Old Pension Scheme, an unfunded DB scheme. His last drawn salary at retirement is Rs 90,000 a month. His pension is 50% of that — Rs 45,000 a month (plus dearness relief), paid every month for life directly out of the state government's budget. No dedicated corpus was ever built for him individually; the government pays it out of current revenue, the same way it pays any other year's expenses.

Contrast this with a Central Government employee who joined in 2010 — after the cutoff — who is instead in the NPS, a defined contribution scheme, and whose eventual pension depends entirely on how the accumulated corpus performed and how it is annuitised.

Chapter 1, section 1.1.1 (Transition from Defined Benefit to Defined Contribution), builds the entire retirement-planning rationale on this DB-to-DC shift. Expect direct recall of the DB definition, the funded/unfunded distinction, the 50% of last drawn salary OPS figure, the 1 January 2004 cutoff date, and the Project OASIS/S.A. Dave committee background.

• "Funded" and "unfunded" describe whether a corpus was built in advance, not whether the pension itself is guaranteed — both funded and unfunded DB schemes promise a defined benefit.
• The OPS pension is 50% of last drawn salary, paid from the government's current budget, not from an accumulated investment corpus. Confusing OPS with a funded pension is a common error.
• 1 January 2004 is the DB/DC dividing line for Central Government employees — service starting before it means OPS (DB); on or after it means NPS (DC).
• Under DB, longevity risk and investment risk sit with the employer/government; under DC, both risks shift to the individual — this reversal is the single most tested conceptual point in the chapter.