De-mystifying Defined-Benefit and Defined-Contribution pension plans.
If you’ve been following recent governmental announcements regarding pensions and financial services, you may have seen references to different pension plan types. If this has left you mystified about what it means for you, read on as we break it down.
When it comes to private pension plans, particularly those taken within the workplace, there are two types: Defined Benefit and Defined Contribution. With the former, your pension pot is based on how long you’ve worked for the employer and/or your salary – this can be either your finishing salary or your average salary whilst with the employer. On the other hand, a Defined Contribution pension pot is based on how much has been paid into the pension plan.
Defined Benefit pension plan
Defined Benefit plans are most common in public sector positions and in very large businesses. With these pension plans, both the employer and employee contribute to the pension pot, with the employee receiving tax relief on contributions they make. This means that tax is paid into the pension pot rather than to the government. The plans are further divided into final salary schemes, where pension income is calculated using the employee’s salary when they left the scheme or retired, and career average schemes, where pension income is calculated based on the employee’s average salary throughout their time with the company. There are many advantages to a Defined Benefit pension plan for the employee, as the scheme is covered by the Pension Protection fund.
They will receive a guaranteed level of income from their pension upon retirement, and therefore have more certainty and security. Their pension income will increase each year in line with inflation and they do not need to be concerned with managing their spending during retirement, as the funds will not be used up at any point. Payments will continue to be made to spouses and dependents upon death as determined by the pension scheme policy details. One drawback of the Defined Benefit scheme is that the employee has very little control over their funds until the point of retirement. They are not able to have a say in the investments made on their behalf. The risk with a Defined Benefit pension plan is held by the employer. No matter what happens to the funds that are invested on behalf of the employee, typically in a range of assets including company shares and long-term government bonds, the pension payout is guaranteed at a set level.
Therefore, if the return on investment is poor, the pension pot may not have grown enough to cover payments. This does not impact the employee but will cost the employer. Defined Benefit pension plans are managed by a Board of Trustees on behalf of the employer, and the administration that goes alongside this means that Defined Benefit plans are also more expensive for the employer to run that the alternative Defined Contribution plans. This is one reason why the majority of Defined Benefit pension plans are now closed to new members. It is possible you may have one from a previous employer, however.
Defined Contribution pension plan
Nowadays, most workplace pension schemes will be Defined Contribution schemes. With this type of plan, the amount an employee receives on retirement is dependent on how long the pension plan is held for with contributions being made, how much is paid in by the employee and employer and how much the pension pot grows. With most of these pension schemes the pot is invested to try and increase the value of the pot. As the employee gets closer to retirement age they can choose to invest in less risky investments – this may be offered automatically by the pension provider or the employee can request it.
Defined Contribution plans allow the employee much greater influence over the investment of their pension funds. However, the risk is also held by the employee. Should the investments made not be profitable, or if there were a stock market crash, the pension pot could be diminished. Working with a financial services company such as Willday Wealth Management can help to mitigate this risk as they will be on-hand to advise when funds should be moved.
Whilst employees’ contributions are eligible for tax relief as with a Defined Benefit plan, the pension pot may also be subject to fees from the pension provider. Once the employee reaches 55, they are usually able to draw down 25% of the total pension pot tax-free. The remainder of the pot will then be taxable.
Defined Benefit v Defined Contribution
On the surface, it may seem that a Defined Benefit scheme is more advantageous for employees than Defined Contribution schemes. A Defined Benefit scheme is secure and will increase in value through inflation, whereas a Defined Contribution scheme increases through investment. This has a risk of decreasing too, of course. Defined Benefit schemes are inherently less risky for employees, therefore.
However, it is not as straightforward as saying there are no advantages to a Defined Contribution scheme over a Defined Benefit. For example, if the pension holder dies before the age of 75, with a Defined Contribution scheme the pension can be inherited by any beneficiary that is chosen. With Defined Benefit schemes, details are determined by the scheme, but it is usually spouses and dependents alone that can inherit it. There is also more flexibility with a Defined Contribution pension when it comes to payments – employees can determine how much and when they receive payments. With a Defined Benefit pension, a set amount is paid out per year. Retirement benefits are also available from a younger age with a Defined Contribution plan – typically funds can be drawn down from the age of 55, as opposed to the state retirement age for Defined Benefit plans.
Lost track of your pension details?
If you think you may have missing pension pots, but you’re unsure who the pension provider may be, we’ve got you covered. Similarly, if you’ve changed your name or moved house without letting your pension provider know, you may have funds in pots you don’t know about! Our free Find My Pension service can help you track them down. Find out more about the service here and get started by completing our short form here.
