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Defined benefit versus defined contribution pension

11th June 2019

Employer-sponsored retirement plans are divided into two categories: defined benefit pension plans and defined contribution plans.

What is a defined benefit plan?

A defined benefit plan is a type of pension plan in which your employer/sponsor gathers up all the funds and promises a specified payment upon your retirement. The amount paid to you is pre-determined by a formula based on your earnings history, tenure of service and age. If you’ve worked for a large employer or in the public sector, check whether or not you have a defined benefit plan.

How does it differ from a defined contribution plan?

If there is confusion around the difference between a defined benefit and a defined contribution pension plan, the differences in the names – contribution versus benefit – can help.

Who contributes to it?

As the names imply, with a defined benefit pension plan, a specified payment amount is provided in retirement. The employer contributes to this and the employee benefits from this (when they retire).

A defined contribution plan on the other hand, requires the employer and employee to contribute and invest funds over time to save for the employees retirement. A person contributes a portion of their salary to a pension scheme. Ideally – although not always – their employer also contributes and these contributions are invested in a fund in order to provide retirement benefits. Defined contribution plans are funded primarily by the employee, with the employer matching contributions to a certain amount.

What’s promised

In both cases, all you need to do is attend your work and – assuming you meet basic eligibility rules – you’re automatically enrolled in the plan. Note that in some instances, you aren’t enrolled until you’ve completed your first year on the job. You usually also need to remain in the job for several years – typically five – to be fully vested in the plan. Check this with your employer/pension provider.

The main difference between a defined benefit scheme and a defined contribution scheme is that the former promises a specific income and the latter depends on factors such as the amount you pay into the pension and the fund’s investment performance.

A defined contribution plan requires you to put in your own money and credits your account with a set percentage of your salary each year. As mentioned, the amount of pension funds you’re paid from your employer with a defined benefit plan is based on a formula that takes into account how long you were on the job and your average salary during your last few years of employment and is not dependent on how much you pay in or how well the fund’s investments perform. These key differences determine which party, the employer or employee, bears the investment risks and affects the cost of administration for each plan.

Can you transfer your defined benefit pension?

Another difference is that defined benefit pensions tend to be less portable than defined contribution plans. With a cash-balance plan, if you leave the company before retirement age, you can take the contents of as a lump sum and roll it into an IRA, whereas a traditional pension isn’t portable.

Are defined benefit pensions good?

Yes. Defined benefit pensions are paid by your employer and can provide a secure income for your retired life that increases each year that you work. Your employer contributes to the scheme and is responsible for ensuring there’s enough money at the time you retire to pay your pension income. And they usually continue to pay a pension to your spouse, civil partner or dependants when you die. You can contribute to the scheme to top it up too.

If you have a defined benefit plan at your company, consider yourself lucky. Defined benefit plans are more costly for employers than defined contribution plans, therefore many employers have scaled back dramatically or eliminated these plans altogether in recent years.

Some employers offer both defined benefit plans and defined contribution plans. If yours does, participate in the defined contribution plan as well because more often than not, the amount of your defined benefit plan won’t be enough to allow you to live comfortably in retirement.

Will it be protected?

Defined benefit schemes are protected by the Pension Protection Fund. Find out more about this on the government website.

Are defined contribution plans protected?

Defined contribution pensions are usually run by pension providers, not employers. So, you won’t lose your pension pot if your employer goes bust. If the pension provider was authorised by the Financial Conduct Authority and cannot pay you for some reason, you can get compensation from the Financial Services Compensation Scheme (FSCS).

Are defined contribution plans good?

There is tax relief on this type of pension and the benefits at retirement are dependent on a number of different factors such as the contribution levels, how the fund performs as an investment, plan charges and fees, and the annuity rates available when you retire.

Whether you are after advice pertaining to your own pension or are a business client looking to set up a workplace pension scheme, our pension advisory service can provide the information and expertise that you need.

 

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