Pensions: What’s the difference between defined contribution and defined benefit?

Defined contribution (DC) schemes have overtaken defined benefit (DB) schemes as the pension plan of choice offered by employers. But there is often confusion as to which is the better option. What are the key differences between DB and DC pension schemes, and are there pros and cons to both?

John O’Hara, actuary and private client adviser with Davy, points out some key distinctions between the two very different types of occupational pensions.

Certainty

Defined benefit schemes are by their nature lucrative and (generally) lock tight. “With a defined benefit plan, retirement benefits are calculated based on an employee’s salary and service so members have an element of certainty in the level of pension they will receive,” explains O’Hara. In contrast, with a defined contribution scheme, retirement benefits will be based on the value of the member’s defined contribution pension account at retirement age. This means it isn’t possible to know in advance what pension benefits a member will receive. “The value of contributions paid grows or falls in line with investment growth of the chosen fund,” says O’Hara.

Contributions

It’s easy to see why employers have begun to forgo DB schemes in favour of DC offerings. In a DB scheme, the member pays a set contribution with their employer meeting the balance of the cost of providing the benefits. With a DC scheme, the member and employer both contribute into a member defined contribution account at set (defined) contribution rates of salary, O’Hara explains. Some DC schemes allow members to choose the level of contribution they wish to pay, with a related employer contribution, while members can also bump up their level of contribution by making additional voluntary contributions (AVCs).

Responsibility

With a DB scheme, the buck stops with the employer. “The responsibility is with the company to ensure that the scheme has sufficient assets to pay out all retirement benefits,” O’Hara explains. DC schemes do not offer any such guarantees and members bear all the investment risk. “Trustees typically provide a range of investment funds for members to choose from, however,” O’Hara notes.

Duration

Timing is everything – with a DB scheme, the pension is payable to the member for life, “often with a reduced pension payable to their spouse in the event of their death”, O’Hara says. Members of a DC scheme generally continue to invest in their pension fund post-retirement in what’s known as an approved retirement fund while drawing out an annual income but O’Hara warns there is a “risk that the fund could be exhausted in the course of retirement”.

Options

So, you’ve reached retirement age – what now? O’Hara explains that members of a DB scheme have the option to take a lump sum at point of retirement by giving up a portion of their pension, if that’s what they’d prefer. Overall, however, there is a lack of flexibility in benefits with a DB scheme – it offers a defined level of income from a defined retirement date. Members of DC schemes do have an alternative: they can exchange the fund with an insurance company at retirement for a guaranteed pension for life, known as an annuity. This in itself can incur significant costs so it’s wise to seek advice from a qualified financial adviser.