Defined Benefit vs Defined Contribution

Brett Alegre-Wood
March 12, 2009

What's the difference?

This week we have been looking at the decline of “defined benefit” (DB; or otherwise referred to as salary-related) occupational pensions and the rise in defined contribution (DC; or money-purchase) occupational pensions. Why are more employers closing their door on defined-benefit schemes and only offering new employees defined-contribution pensions? And what does this mean for you and your pension investments?

Occupational pensions were originally set up as an incentive to attract and retain employees. The modern schemes began with Louis XIV of France to entice people to sign up to the Navy and was partially subsidised by the sale of the booty captured by their warships. This was an example of today's defined-benefit scheme, where the employer shoulders the burden of supplying the employees' pension income based on their pay and length of service.

In contrast, defined contribution schemes appeared around 30 years ago and shifted the risk to the individual, with the eventual pension total dependent on investment performance and amount contributed. Previously, the majority of occupational schemes were defined benefit, however by 2014 the amount of money saved in defined contribution pensions will exceed the amount of money invested in defined-benefit. The switch has been prompted by the realisation that defined benefits pensions are unmanageable and increasingly expensive when including protection against inflation and provision for longer retirements.

Much of this was concealed by the bull market of 1982-2000, where investment returns outpaced the rise in pension liabilities, but with the bear market of 2002-03 and falling interest rates, the cost of defined-benefit schemes have become unsustainable. The current economic downturn may speed up the conversion of defined benefit to defined contribution schemes with the proportion of employers expected to switch new employees to defined contribution pensions rising from 21% in July 2008 to 45% in January 2009.

The uncertainty of your final defined-contribution pension pot is by no means the only drawback of these schemes. One of the principal disadvantages is that the level of contributions from both employers and employees into defined contribution pensions are significantly lower than those invested in defined-benefit schemes. In October 2007, the average employers' payment into defined-contribution schemes was just 5.8% of payrolls compared to 14.2% paid to defined-benefit pensions. The difference is not made up by employee contributions either with an average of 3% of salaries invested in defined-contribution schemes, bringing the total to just 8.8% in contrast to the 19.1% contributed to defined-benefit pensions.

Ultimately, it is the final value of your pension pot that suffers.

The estimated difference calculated by Watson and Wyatt is over a 50% reduction in pension return with a median 25-year old contributing at the British defined contribution rate earning about 30% of their final salary compared to 66% of their final salary when contributing defined benefit rates for 40 years. Furthermore, this valuation does not even take into account annual costs of defined contribution schemes that can reduce the overall return.

With the rise in the proportion of companies only offering defined contribution schemes the number of people in these plans will increase and many may remain oblivious to the consequences of defined-contribution pension membership.

Hopefully, this investment blog will bring to your attention the shortcomings of defined contribution pensions (if you are not already aware) and prompt you to appraise your defined-contribution pension plan (if you are contributing to one).

Will it be sufficient to fund the retirement lifestyle you dream of?

Warm regards,
Dr Danielle Aw, PhD
Senior Research Analyst


UK Pension

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