Defined benefit vs defined contribution pension plans

What are the main differences in these types of pension scheme?

Firstly in terms of guarantees - defined benefit schemes offer a promise of an income in retirement with a sponsoring employer standing behind that promise. Defined contribution schemes offer no such promise - what you get in retirement will be determined by the value of your pot when you retire. That pot will provide you with an income but there is no guarantee of what that will be. or if the pot will run out before you die

Defined Benefit schemes tend to be run on a collective basis, whereas Defined Contribution schemes are individual products. This means that Defined Benefit schemes are based around a theoretical average member, with average life expectancy, average pay rises. Someone who lives a long time and who leaves a dependent who receives a pension may, personally benefit more than someone who will not live as long and who has no surviving dependents. Some people will fare better than others out of this collective model.

A big area of risk is the return on investments. In a Defined Contribution scheme, if your investments perform very well then you should be on track for a better retirement whereas poor investment performance means that you, as a member, lose out. In a Defined Benefit scheme, poor investment performance means that a sponsoring employer has to find more money to meet their promise.

Similarly with life expectancy - if people are living longer, then a Defined Contribution member will have to make their savings last longer, whereas a Defined Benefit scheme member will not see their pension changed, but rather the sponsoring employer would have to find extra money to pay the pension for longer.

There is no way of knowing if someone would be better or worse of under a Defined Benefit or Defined Contribution scheme - a good Quality Defined Contribution scheme could give a much better outcome than a poor Quality Defined Benefit scheme.

Do I get a choice of pension type?

The short answer is no. Schemes are either defined benefit or defined contribution and almost all new schemes are defined contribution. Many companies have closed their defined benefit schemes to new employees arguing that they cannot afford them. Public sector schemes such as Civil Service are still defined benefit, though many have recently amended their rules for the majority of members.

Should I transfer from a defined benefit to a defined contribution scheme?

A transfer of funds from a defined benefit to a defined contribution can happen for several reasons.

Sometimes an employee in a defined benefit scheme moves to a new employer and may be able to transfer their benefits to their new employer’s defined contribution scheme.  Ask for advice (from your new employer’s pension provider) on the value of your pension transfer and clarify any costs included in this process. Always seek independent advice.

Some employers offer employees a transfer to defined contribution scheme when they are closing or have closed a defined benefit scheme. This often includes a financial incentive called an enhanced transfer value. Any such offer must meet the principles laid down by the Pensions Regulator including access to independent financial advice.

Independent advice is that a transfer is not generally in a member’s best interests. This is because the final pension is unlikely to be as high as it is in a defined benefit scheme.  But some circumstances may make a transfer attractive – for example where life expectancy is limited, there are no dependents or where the individual wishes to manage their investment portfolio more actively.

The golden rule as always is to take informed advice. Trustees can give general advice and independent financial advice should be available.

Do I have to be a member of an employer’s scheme?

No. All eligible employees will be automatically enrolled on the scheme but have the right to withdraw.

Most advice however is to be part of the scheme whether it is defined benefit or defined contribution and to start as early as possible. This gives you access to the employer’s contribution, is tax efficient and maximises the accumulation of investments over time.