Consider the following scenario. Your employer says to you that when you retire, they promise to pay you £X every month until you pass away. That key number – X – will be calculated based on the number of years you worked for them, and your average or final salary during the time that you worked for them. This is called a ‘defined benefit’ (DB) pension scheme. Because of differences in salaries and tenure at the firm, the number X will differ for different people who retire from your employer’s company. The number might also differ by person if your employer decides to change the rules of the calculation. If this happens, usually only new employees are subject to the new rule, while existing employees (at the time of the rule change) continue being subject to the old (usually better) rule.
Defined benefit pensions are increasingly rare in the United Kingdom because they are expensive and risky for employers. Employers take on most of the investment risk associated with the pension, because whatever happens to the money they’ve put aside for your (and your colleagues’) retirement, they must fulfil their promise of paying you your defined benefits. Business risk – the risk that your employer goes bust – is, however, mostly borne by you. We discuss what happens to a private DB pension scheme when a company fails in a separate article.
A defined contribution (DC) pension, in contrast, is one where your employer makes no promise of paying you any amount of money between retirement and death. Instead, they hand off an amount into your pension ‘pot’ each month while you are still working at the firm, and that pot then gets invested on your behalf (with as much input as you choose to have). Investment risk is borne entirely by you; if financial markets fall then typically your pension pot will lose value. If that happens right before your planned retirement date, then you’re extremely unlucky. Your employer relinquishes all investment risk associated with your pension. Because of the separation of your pension from your employer, however, it is also the case that you don’t bear as much business risk should your employer go bust. Your pension pot is independent from your employer, so it remains intact when your employer fails, assuming nothing dodgy was going on.
Defined contribution pension schemes are increasingly the norm in the United Kingdom. Most young people will have defined contribution pensions, while many middle-aged people might have both types from either different employers or the same employer. There are not many open defined benefit schemes still accepting new members in the UK. For comparison, the standard state pension paid by the government to all retirees who paid national insurance during their lifetimes is a defined benefit pension scheme. There are still many local government employers offering defined benefit pension schemes, so many teachers, nurses, and those who work in the police and fire departments will still have defined benefit pensions.
As a rule of thumb, defined benefit pension schemes are attractive to the employee, and they generally amount to being more generous than defined contribution schemes, most of the time. So, if you have a defined benefit pension, don’t give it up! We will, however, discuss pensions in much more detail in our blog, including the choice that many people have to transfer out of their defined benefit schemes into defined contribution schemes. It is very rarely advisable to do such a thing, but more on that in future articles.
To the pound 