Defined Benefit vs. Defined Contribution Pension Schemes

Introduction to Pension Funding and Provision

Pension schemes refer to arrangements for providing retirement benefits. Occupational schemes are established by employers, or by a set of organizations, to provide at least one employee with benefits. In private sector firms, these schemes, linked to trustees, are regulated through trust law. Two key forms of occupational pension scheme exist (Banks et al., 2002). The first is the defined benefit plan, wherein rules lay down the benefit rates to be disbursed. The "final salary" plan is the most widely adopted defined benefit plan; however, "career average" plans have been increasingly gaining importance in recent years. The second form is the "money purchase" or defined contribution plan, wherein benefits are governed by paid-in contributions, their investment returns, and the nature of the annuity purchased at the time of retirement.

Defined Benefit Schemes

Sometimes called final salary pension plans, defined benefit schemes are primarily employer-sponsored, although staff members may also be required to make regular contributions. Such plans accord employees a certain percentage of their final salary — just prior to retirement, or at the time of leaving the organization — as yearly income. The percentage is determined by the employee's tenure with the company. Generally, employers fix "accrual rates" as a share of employees' final salary. For instance, if the accrual rate is fixed at 1/60th, retiring employees will receive 1/60th of their final salary (i.e., their salary at the time of leaving) as retirement income for every year they have worked for the company. Thus, an employee who has served the company for thirty years will receive 30/60ths — that is, half — of their final salary (Banks et al., 2002).

Pension schemes in the defined benefit category must ensure they hold adequate assets or resources to meet their liabilities at the time they fall due. If liabilities surpass assets, the pension plan will face a deficit or funding shortfall. In such instances, sponsoring organizations tend to raise contribution levels. When pension assets surpass liabilities, the plan will be in surplus, and organizations occasionally offer "contribution holidays" — that is, breaks from contributing — to employees (Mercado, 2012). Asset performance and the nature of liabilities together determine whether a pension plan will be in surplus or deficit.

Assets of pension plans are usually valued on the basis of market price and can therefore be estimated with relative ease. Measuring the liabilities of pension schemes is considerably more difficult. Several factors must be taken into account, including the period over which each member must be paid a pension (which depends on the individual's life expectancy) and the annual rate of pension increase. The future payment stream must subsequently be estimated in terms of "present value" using the discounting method, which converts the value of future payments made over time into an equivalent current value. For fixing contributions, the scheme-specific financing regime of the United Kingdom requires agreement between the sponsoring company and the scheme trustees on a suitable discount rate — determined in accordance with actuarial recommendation — in collaboration with the Pensions Regulator (PTR) (Pension Protection Fund and The Pensions Regulator, 2014). This liability measure, known as Technical Provisions, differs across schemes.

The most comprehensive dataset for estimating defined benefit plan liabilities in the United Kingdom is the one used to compile the PTR and PPF's (Pension Protection Fund's) Purple Book (2014). This Purple Book values liabilities for PPF plans — chiefly private sector plans — using two techniques: the s179 (Section 179) approach and the total buy-out method. The former estimates the cost of purchasing PPF compensation levels through an insurer, while the latter gauges the cost of insuring the total scheme. The Technical Provisions measure falls between these two liability measures.

Strengths of Defined Benefit Schemes

A key strength of defined benefit schemes is that no investment effort is required on the individual employee's part. The organization and trustees are responsible for ensuring the fund meets its obligations. While some risk is involved — particularly in the event of organizational insolvency — all funding shortfalls must be compensated by the organization through increased contributions. The employer offering the defined benefit scheme is tasked with contributing to the scheme and making individual investment decisions. Employees simply need to perform their jobs, and their retirement benefits will be available when they retire (Wilson, 2014).

One of the greatest advantages of defined benefit plans is security. Employees enrolled in such plans know the precise amount of money they will receive upon retirement. They need not worry about market performance, as the amount will always be available when they choose to retire (Cannon & Tonks, 2012).

The Pension Benefit Guaranty Corporation (PBGC) represents another source of protection for those covered by defined benefit schemes. This governmental agency oversees a number of defined benefit plans. Organizations that use this form of insurance are required to pay a specified annual premium for individual pensions. If an organization runs into difficulty, the PBGC steps in and covers the pension of all enrolled employees (Cannon & Tonks, 2012).

A further advantage of this type of retirement scheme is that employees know precisely how long they must work before retiring. Such plans provide employees with a predefined sum of money that accounts for each year of service given to the organization. With other forms of retirement plan, the outcome is essentially uncertain. Employees must wait until they reach the specified retirement age; however, they also have clarity on when they should seek retirement (Wilson, 2014).

Money Purchase (Defined Contribution) Pensions

Also called defined contribution plans, money purchase pensions accumulate savings in a personal, individual pension fund. This method is used for saving in the majority of personal pension arrangements. Such plans differ in how funds are invested and in the level of charges applied (Mintel, 2010). They can be categorized as follows:

Workplace Pension Plans — In this arrangement, employers and employees together make regular monthly payments, and the amount is invested by a pension firm until the employee reaches retirement age. Workplace pensions are principally of two kinds: contract-based and trust-based pension plans.

Trust-Based Pension Plans — A Trustee Board manages investments on behalf of employees. Both employees and, often, their employer pay into pension pots, and the funds are invested through a trust fund that is kept at arm's length from the organization. This arrangement also allows benefits to be passed on to the employee's spouse, partner, or other dependent individual (Mintel, 2010).

Stakeholder Pensions — These pensions resemble workplace pensions but are distinguished by flexible and low minimum contributions, a default investment choice, and capped charges. Employees are not required to make decisions about where to invest their money.

Group Personal Pension Plans — Such a pension is an arrangement between workers and a third-party insurance provider, which is not obliged to act in the employee's best interests. While the employer selects the insurance provider, these arrangements typically offer employees a range of investment choices.

SIPPs (Self-Invested Personal Pension Plans) — While they function similarly to the plans above, SIPPs are do-it-yourself pensions that allow employees to choose their own investments. Investors who are willing to perform the necessary research themselves can run SIPPs at low cost, provided they use the right insurance provider (Mintel, 2010).

References

Banks, J., Blundell, R., Disney, R., & Emmerson, C. (2002). Retirement, pensions and the adequacy of saving: A guide to the debate. IFS Briefing Note No. 29.

Cannon, E., & Tonks, I. (2012). The value and risk of defined contribution pension schemes: International evidence. Journal of Risk and Insurance. doi:10.1111/j.1539-6975.2011.01456.x

Mercado, D. (2012). In apparent first, a public pension plan files for bankruptcy. Pensions and Investments.

Mintel. (2010). SIPPs — Finance Intelligence, December 2010. Retrieved from http://reports.mintel.com/display/480963/

Pension Protection Fund and The Pensions Regulator. (2014). The Purple Book: DB pensions universe risk profile: 2014. Retrieved from http://webarchive.nationalarchives.gov.uk/20160105160709/http://pensionprotectionfund.org.uk/pages/thepurplebook.aspx

Wilson, K. (2014). New investment approaches for addressing social and economic challenges. OECD.