If you are thinking about saving for retirement through a workplace pension scheme, you may have come across the terms defined benefit (DB) and defined contribution (DC). Both are private pension plans set up by your employer (or you, in some cases), but they work quite differently.
DB schemes are always set up by your employer. The amount you receive as a pension is dependent upon how long you’ve worked there and how much you earn, so they are often known as final salary or “salary-related” schemes. Once you retire, they pay out a secure, specific, typically inflation-linked income for life.
However, DB schemes are very expensive for employers, especially as life expectancy has risen over recent decades.
Closed and Frozen
Of the rest, 40% were closed to new members by March 2020, while a further 47% were effectively frozen, in that existing members cannot build any further benefits in the scheme. The percentage of frozen schemes has risen from 28% in 2012.
DC schemes work quite differently from their DB counterparts, in that there is no specific level of income guaranteed when you retire. They are basically investment pots and so the amount you have to live off in retirement will depend on how much has been contributed, how long it has had to grow and how successfully it’s been invested.
DC plans can be workplace pensions set up by an employer, in which case your employer may well make contributions as well as you. If it’s an auto-enrolment scheme, the government stipulates minimum contribution levels for both you and your employer. But you can also set up your own personal DC pension (Sipps are one example).
Contributions go into an individual pension pot held in your name, though you can select the fund in which they are invested from the limited range offered by your plan provider. If you don’t choose a fund, your money will usually be paid into the so-called default choice, but you are free to move it from one fund to another at any time. A staggering 95% of workplace scheme members have their cash in the default choice.
Pros and Cons
So how do the relative strengths and weaknesses of DB and DC pensions line up?
As Steve Webb, partner at pension consultancy LCP, explains, the big attraction of a DB plan is the security of knowing you are guaranteed a specific, inflation-linked, income for the rest of your life – regardless of what happens to stock markets.
“Pretty much all of the uncertainty associated with pensions – how long you will live, how your investments will perform, how inflation will erode the value of your pension – fall on the sponsoring employer and not the member. This certainty should not be given up lightly,” he says.
In the relatively unlikely event that the employer goes out of business and cannot afford to honour its DB pension commitments, the government-backed Pension Protection Fund operates as a safety net. Under this scheme, 90% of expected benefits will be paid to members below retirement age, while those already retired normally receive 100%. Payouts are capped: currently the cap stands at just over £30,000, but it varies with age.
Webb adds that DB pensions can be more flexible than is often realised. “For example, although a DB pension will have a ‘normal pension age’, you may be able to take a pension at a reduced rate ahead of normal age,” he observes.
“Similarly, many schemes offer flexibilities such as a ‘bridging pension option’, where you can have a higher pension from the scheme before state pension age and then a lower pension when the state pension cuts in.”
Against the huge DB attraction of income certainty, the attraction of DC pensions lies in the fact that they have been made very flexible, says Webb: “The revolution in DC pensions came with the introduction of Pension Freedoms in 2015. Until then most people had to use their DC pot to buy a guaranteed income through an annuity, often securing rather poor value. Pension Freedoms mean anyone aged 55 or more can use their pension flexibly.”
Thus while you can still buy a guaranteed income through an annuity, it has become increasingly popular to leave the money invested and take an income through drawdown. This gives flexibility to stop, start and adjust the amount taken, or indeed to cash an entire pension in.
Moreover, says Webb, “it’s possible to use your pension cash to facilitate early retirement or perhaps even to free up capital to pay off debts, support other family members or enjoy a holiday of a lifetime.”
Additionally, you can bequeath any money remaining in your DC pension to any beneficiary you choose – family, friends or charities. Final salary pensions, in contrast, provide some continuing income (typically 50%) for spouses, civil partners and dependent children if you die, but cannot be inherited.
If such flexibility appeals, it is possible to transfer out of a DB pension scheme and into an investment-based one – but in most cases it’s not the best decision, as the responsibility for managing your retirement funding will rest fully upon your shoulders, there’s no guaranteed income and you will be dependent upon the fortunes of the markets. You’ll have to take financial advice if your pension pot is valued at more than £30,000.