What's the difference between defined benefit and defined contribution?

Types of pension

There are two main types of pension: the defined benefit scheme and a defined contribution scheme.

Defined benefit scheme

The defined benefit scheme is a pension that rarely exists now in the U.K. Most of these schemes are coming to an end due to their expense to the companies that used to offer them.

Defined benefit schemes worked in such a way that your employer would provide an income for you even after retirement. This would normally be a percentage (say 30%) of the average of your last few years of income.

The problem with the defined benefit scheme is that generally employers never used to put enough aside in order to fund these former employees. Generally, the actual returns on their investments were lower than expected and people generally lived longer than expected. As a result most defined benefit schemes underfunded and did not grow to the size that the liabilities required.

Defined contribution scheme

The defined contribution scheme puts the responsibility of a pension back into the hands of the employee rather than the employer. Employees are expected to put money aside into their own pension pots. Employers generally match the employee contributions up until a certain point. 

The money that an employee puts into their pension is tax free. So the more that an individual puts into a pension, the smaller the amount of tax that they pay. As for the employee they're just relieved that the responsibility to fund former employees in retirement is out of their hands.

Do I have a defined benefit pension or defined constitution pension?

Chances are you have a defined contribution scheme. If you're making any sort of regular contribution and your employer is matching then you've got a defined contribution scheme. There are only a few legacy defined benefit schemes left in the U.K. and most are at serious risk of not being able to support new employees in retirement.

Which type of pension is better?

There are various pros and cons of each type of pension scheme. The defined benefit scheme was great as it guaranteed employees had their retirement sorted - individuals didn't have to think about it at all. They knew that they'd be looked after in retirement. The payout of these schemes were incredibly generous. If you discover that you're in a defined benefit scheme then for heavens sake do not sell it. My fiancé's grandpa used to work for sainsburys. He's now 87 and still earns a salary/pension from sainsburys. They've offered him multiple times to buy him out. However it's simply too valuable and they'd have to offer an awful lot of money for him to concede.

However, there are major risks with a defined benefit scheme. If the company that's funding the scheme goes bust and is underfunded for existing members of the scheme then you're screwed. This is what happened to BHS pension scheme. The company went bust and had underfunded the pension to the tune of over half a billion. There is very little likelihood of ever recovering that money for retirees.

Whilst the defined contribution scheme is probably considerably less generous in terms of the employers contribution it has its own benefits. The defined contribution scheme allows for easy control by the individual when it comes to retirement. The individual has control over where the pension can be invested. The final pension pot can be used to buy an annuity or invest in other products or simply taken as cash. Finally, should you die before you've fully utilised your defined contribution pension then the pension is free from inheritance tax for your next of kin. Unfortunately this isn't the case with a defined benefit scheme.

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