Comparing Defined Benefit and Defined Contribution Schemes
Private pensions are very versatile, but at a fundamental level, they can be either Defined Benefit (DB) or Defined Contribution (DC) schemes.
As the name implies, DB schemes promise a guaranteed (or ‘defined’) income at retirement which depends on a number of factors, typically including your earnings just before retirement and how long you worked for.
DC schemes don’t guarantee any income at retirement and the value of your pension pot at retirement (and thus, what you can take out) depends entirely on how much you contributed and how the investments performed that your money went into.
Troubles with DB schemes
DB schemes used to be the norm. Interest rates were high during the 1970s so it was possible for employees to earn a decent return on the contributions made by employers and thus live up to the promise of a guaranteed income in retirement [1].
However, with interest rates steadily declining since then, employers increasingly struggled to make good on their promise. More and more schemes became ‘unfunded’ (or ‘in deficit’, i.e. did not have sufficient to cover the promised incomes); as of 2018, the number stood at 63% of schemes covered by the Pension Protection Fund (which is mostly private sector schemes), and there have been a number of high-profile failures where the pension schemes need to be rescued such as with Carillion [2].
On top of this, most public sector DB schemes are also unfunded - including, for instance, the NHS and teachers' pension schemes.
Move towards DC schemes
DB schemes often used to be described as ‘gold-plated’ because of their promise of guaranteed income. While this sounds re-assuring it ultimately means little when there is no pay-out or the scheme needs to be rescued.
Thus, while DB schemes remain prevalent in the public sector, it is no surprise that DC schemes are surging in popularity as DB pensions fall out of favour in the more flexible private sector. Active members in private sector DB schemes have steadily been declining since the late 1970s, falling from about 6m [1] then to just 1.2m [3] in 2018 (which includes a 50% decrease since 2010 alone) [3]. To put this into perspective, as of 2018 there were roughly 15m active members in DC workplace pensions alone [4] and this number has been increasing rapidly.
Not only does DC do away with the issue of funding deficits (as income is not guaranteed), but they are generally much more flexible and easy to understand. They don’t bog users down with complicated scheme rules to determine pay-outs like DB, they are portable (i.e. you can continue to contribute when leaving an employer and can transfer pots more easily), and they generally offer much greater flexibility both in terms of contributions and withdrawals at retirement. However, with DC schemes, the amount can go up and down depending on the performance of the investments in which the money has been invested.
We believe the flexibility inherent to DC schemes is key to the future of savings, and we are looking to harness this to create a suitable solution for an increasingly flexible workforce.
A new type of scheme: Collective Defined Contribution (CDC)
A new type of scheme known as ‘Collective Defined Contribution (CDC)’ is currently undergoing consultation and may be live in the UK soon. The Pensions Scheme Bill 2019-20 has laid out a framework for CDC.
CDC schemes contain elements of both DB and DC schemes, meaning the risk does not sit exclusively with the employer (as in DB schemes), or the employee (as in DC schemes). Scheme members’ contributions are pooled and invested together which enables some economies of scale. The scheme targets a certain level of income for its members but this is not guaranteed – there is thus some degree of predictability but no rigidity as would be the case for DB schemes.
The first trial of a CDC is expected to go ahead soon with the Royal Mail.
See also our article on CDC in Recent Legislation & Initiatives.
Sources
[1] Rowena Crawford, Carl Emmerson, Gemma Tetlow; Occupational Pension Value in the Public and Private Sectors; April 2010
[2] Pension Protection Fund; The Purple Book 2018; December 2018
[3] TPR; The DB landscape; November 2018
[4] The Pensions Regulator; DC trust: presentation of scheme return data 2018 - 2019; 2019
