With the decline of final salary pensions in recent years, many people are rightly asking whether defined contribution pensions are simply inherently better.
The reasons for this change are numerous, but two big factors have played a part. First is the rising life expectancy of British citizens, making it harder for companies to justify to their boards why they should pay more into final salary pension schemes.
The other big factor is the increasingly mobile workforce we have today. People just move around a lot more in their careers, rather than staying with one company for 40 years.
Under a defined contribution scheme, you build up a pension “pot” with your own contributions – as well as with those from your employer. This pot might be invested a variety of funds, common stock, fixed income securities and annuities, for instance.
Lots of people are requesting transfers into these schemes, away from their final salary schemes. So, on balance which type of pension is better?
Final Salary: Pros & Cons
The advantage of this type of scheme is it gives you a predetermined retirement benefit, usually based on your salary and your years of service at the company. Your employer is therefore responsible for your income, and it gives you a “guaranteed income” for life.
If the fund underperforms, then your employer makes up the deficit. They, therefore, are taking on the bulk of the risk. This is all great for you, but there are some downsides. If your fund underperforms, yes your employer makes up for it. However, this means the business will have to spend less on other areas of the business, and more on the underperforming pensions. Previously planned pay rises, for instance, may have to be halted.
Defined Contribution: Pros & Cons
From the employer’s point of view, this type of scheme offers more certainty. All they need to do is calculate the contributions they need to make each year, and follow their duties in this regard.
From your point of view, this can be a disadvantage. If your fund underperforms, then you could lose out financially. There is no company safety-net to make up the shortfall. This means you cannot know what your retirement income will be, as this hinges on your investment performance.
On the other hand, defined contribution pensions are almost always more flexible than final salary plans. They give you more control over your pension investments, and are much more “portable” between different jobs throughout your career.