What Is the Difference between Defined Contribution and Defined Benefit Pensions?
In this article, our Hertfordshire Financial Planners will clear up all your questions on the difference between Defined Benefit pension schemes and Defined Contribution pension schemes.
The first thing to understand is that this is a difference applied to workplace pensions. This distinction does not apply to your state pension.
When it comes to workplace pensions, there are two major kinds of scheme on offer. The first is Defined Contribution pensions (DCs). The second is Defined Benefit pensions (DBs). We will start with DBs then move onto DCs.
Defined Benefit Workplace Pensions
The fundamental characteristic of DBs is that the benefits received by the retiree upon retirement are ensured by the plan. What exactly they are will depend upon the employer’s scheme. It may take into account variables such as the age, earnings and role of the employee to determine the extent of the benefits paid.
In general, earning more, being more senior and being at the company for a longer amount of time typically result in a more generous promise being agreed.
In DBs, there exists a risk that the employee will contribute less over their time paying into the scheme than the value of benefits they are promised upon their retirement. In this situation, the company’s pension scheme will lose money.
However, the converse also holds; an employee may also contribute much more than they are promised to the scheme and there may be no obligation for the employer to see to it that the employee benefits from this pension contribution surplus.
It is precisely this risk that has caused many employers to switch their workplace pension schemes to DCs.
Defined Contribution Workplace Pensions
DCs remove the risk of a pensions-contribution shortfall by fixing the contributions which are made instead of fixing their promised benefits. It is important to note that what is fixed can be the contributions of the employee or the employer, or both. Commonly, the employer will match the contributions of the employee.
The value of the benefits received upon retirement is then determined by the total value of the investments purchased by the employee’s contributions.
The most significant result of the DC system is that the risks are shouldered by the employee. The employer knows that they will be contributing a fixed amount and so can accurately plan for this expenditure. This is in contrast to the contributing employee, who knows only how much they are contributing, not how much they will receive upon retirement.
The Current State of Affairs
Because of the reasons highlighted, employers are now running away from DB schemes in favour of DCs. The move resembles a landslide, with a 48% decline in DB participation in one year alone.
Is this good or bad news? Concerns that DCs offer worse value for savers than DBs have been voiced since 2013, around the start of the landslide. To ensure you are following the best possible pension plan for you, it is more essential than ever to contact expert retirement planners.