What’s Best? Defined Benefit Vs Defined Contribution
Ever wondered what’s the better pension to have? In this post we take a look at Defined Benefit Vs Defined Contribution pensions.
As the names suggest one type of pension has ‘defined benefits’ and the other has ‘defined contributions’.
Think about that for a moment.
What would you rather have?
Defined Benefit Pension
These types of pension were offered by employers and are more commonly known ‘final salary’ pensions.
What they pay as retirement income will depend on the number of years you have been a member of such a scheme, your final salary and the scheme’s accrual rate (which is the proportion of your salary that will be paid as a pension).
Basically, the longer you are a member of a scheme, and the higher your salary; the higher the pension.
If you left a scheme years ago you will be a ‘deferred member’ with ‘preserved benefits’.
In turn this means the correct calculations must be made for your pension entitlement, and guess what?
The calculations are often wrong!
That’s why we suggest checking out the pension transfer hub GUIDE to DB calculations.
It’s well worth it!
Defined benefit pensions pay generous ‘death’ benefits. Whilst it may be difficult to put death and benefits in the same sentence, these do provide peace of mind.
Before retirement these benefits are referred to as ‘death in service’ benefits and after your death they are simply known as ‘death benefits’. They are usually paid as a percentage (50% or so) to your spouse (husband or wife), civil partner or dependents.
So, What’s the Risk?
Defined benefit pensions are more or less ‘risk free’.
You have no investment risk with a defined benefit pension, unlike other types of pension.
We’d love to tell you defined benefit pensions have ‘No risk’ but this would be incorrect. There is always a risk that an employer sponsored defined benefit pension can end up with the Pension Protection Fund (PPF).
The PPF acts as a ‘lifeboat’ to ensure members of defined benefit pension schemes receive a pension, regardless of whether or not their employer (or ex-employer) becomes insolvent.
Pleasantly reassuring, wouldn’t you agree?
In summary, DB pensions are great. They pay a regular secure income (which rises with the cost of living), for the rest of your life.
Defined Contribution Pensions
Defined Contribution pensions have no guarantees and how much they will pay once you retire will depend on the level of contributions you have made and the investment returns you have achieved, if any.
Unlike Defined Benefit pensions Defined Contribution pensions don’t have ‘death in service’ benefits. This means other types of protection (life insurance, critical illness cover) are more important to put in place.
Whilst many Defined Contribution pensions will offer employee cover, this will not be anywhere as generous as those offered to you in a Defined Benefit pension.
As mentioned earlier, all investment risk is with you when you are a member of a Defined Contribution pension scheme. This is in stark contrast to ‘no investment’ risk if you are a member or a Defined Benefit pension.
In terms of contributions schemes range from ‘non-contributory’ (where an employer makes all contributions) to fixed percentages of contributions (from both employer and you).
Too many of us don’t pay attention to the contribution levels that employers make to our pensions.
If you don’t know, now is the time to find out!
An interesting fact is that the end value will be most influenced by the level of contributions made during the lifetime of the scheme.
Defined Benefit vs Defined Contribution – Income in Retirement
A Defined Benefit pension will pay a set amount each year, for every year that you live. Whether that’s to 75 or 105 you will always receive your income.
And an income that is protected against inflation and keeps up with the cost of living. If you are a member of a Defined Benefit pension scheme you’ll know how much pension you’ll receive each week.
In contrast, careful planning of income requirements is necessary with a Defined Contribution pension. If too much income is taken too early there is the risk that your funds may not last, as long as you do.
A major advantage of a Defined Contribution pension, in terms of income taken in retirement, is that as much or as little income can be taken. Clearly, what may be an advantage to one person may be a disadvantage to another.
Any income shortfalls must be accounted for with full consideration of other assets, pensions and risks.
Being a member of a Defined Benefit pension means you have no investment risk, so regardless of whether the stock market falls or crashes, your pension is safe.
But maybe you’re looking to start taking income from your pension earlier?
Maybe you have sufficient income from other sources that the guaranteed and steady income from a defined benefit scheme is less important.
Perhaps you want to vary the level of income you take?
Maybe the attraction is being able to ‘pass on’ pension funds to whoever you like, in a tax efficient manner.
Do you value a secure and steady income for the rest of your life?
Do you value the flexibility of taking income as and when you like, and potentially having the option of bequeathing the remainder of your pension pot to loved ones?
If you would like more information on the full considerations that should be made in transferring a pension please contact us.