Types of company pension schemes
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Company pension schemes are not all the same in fact they vary
wildly.
However the schemes can be very broadly divided into two
types
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Defined Benefit Schemes (DB Schemes)
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Defined Contribution Schemes (DC Schemes sometimes also
called Money Purchase schemes)
Don't worry if these terms do not make much sense right now.
All these terms are explained later on, unfortunately the pensions
world is packed full of unhelpful jargon!
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Defined Benefit (DB) Schemes
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When we talk about a 'benefit' we are generally talking about
pensions. A benefit is really just another way of describing
either of a pension or cash amount or some other sort of reward.
If for example you get free dental care at work that might be
described as a 'dental benefit'. If your spouse gets a lump sum on
your death this might be described as a 'death benefit'. A pension
might be described as a 'retirement benefit'.
A Defined Benefit (DB) Scheme is exactly that, a pension scheme where the benefit
(i.e. the pension in most cases) is 'defined' in some way.
Therefore it may be helpful to think of this as a "Defined
Pension" Scheme. This means the pension you get is based on some
sort of formula, normally related to salary and service. One quite
popular kind of defined benefit scheme is known as a Final Salary
scheme. In this sort of scheme a member may be promised a pension
of say 1/60th of salary at retirement for each year of service.
Note how the pension promised is in no way related to the amount
of money put in. In a defined benefit scheme the focus is on the
pension not on the contributions paid.
The above is just an example to show what is meant by a Defined
Benefit scheme. The essential thing to remember is that in a
Defined Benefit scheme the amount of pension (or sometimes cash)
available at retirement is defined by a formula usually related to
salary and service.
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Defined Contribution (DC) Schemes
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A Defined Contribution (DC) Scheme (also sometimes described as
a Money Purchase Scheme) is in some ways the complete
opposite of a Defined Benefit Scheme. In a DC Scheme the amount of
money paid into the pension scheme is the focus e.g. the employer may promise to pay 5%
of your salary into the scheme each year. These amounts are then
invested to produce a fund at retirement. However the pension
available at retirement will depend upon the level of
contributions paid, investment returns earned and the cost of
purchasing pension at retirement. These things cannot be known in
advance and hence the pension it produces cannot be known also.
The pension (or benefit) is not defined it is the contributions
which are defined.
The most stark difference between a DC and a DB scheme relates
to which party (company or member) bears the risk.
In a DB Scheme the benefit is promised and the company takes
the risk of meeting the eventual cost of this, the cost cannot be
known in advance and so could be more than the company was
reckoning on.
In a DC Scheme the company pays a set amount into the fund. The
amount of the eventual pension this will buy is unknown and the
member bears the risk that the pension will be insufficient.
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