DB v DC: It’s contributions that really count

If you read nothing else, read this…

The amount of money an employer puts into the pension scheme is more important than whether it is a defined benefit or defined contribution arrangement.

Age and career prospects are important indicators of which type of pension scheme most suitable.

Employee Benefits’ research shows that only 5% of employers pay between 11%-20% of salary as DC pension contribution.

Article in full

While tabloids and trades unions would have you believe that DB pensions are the Holy Grail of occupational pension schemes, it seems that many employees would be better off betting on DC arrangements instead. "Whether it’s defined benefit or defined contribution, the actual benefits structure is secondary. It’s what you put in that matters much much more.

And the bottom line is that you get what you pay for," says Tom McPhail, pensions research manager at independent financial adviser Hargreaves Lansdown. Dr Ros Altmann, an independent pensions expert and adviser to the government, believes there’s nothing wrong with DC pension arrangements, other than they are not being run properly in the UK and that DB schemes have historically been too generous.

So while investment options need to be improved and issues such as fees are important, contribution rates are key. "If I’ve got an employer offering me 10% or 15% of salary into a DC scheme against an employer offering a 1/120th DB scheme, I’ll take the DC scheme thank you very much," says Hargreaves Lansdown’s McPhail. And if an organisation is replacing a DB scheme with DC, it needs to keep an eye on its contribution rates if it wants to replicate the benefit. "If you want to replace a two-thirds final salary pension then the contribution going into a DC scheme needs to be something north of 25% of salary between the employer and the employee. I don’t think that’s do-able but if you want to replicate DB that’s what you need," explains Altman.

Andy Cheseldine, senior consultant at Watson Wyatt, says employers that switch from DB to DC are mistakenly accused of cutting benefits. Most organisations don’t want to reduce the amount they spend, but rather reduce the risk. Employee Benefits/Barclays Pension Research 2004 shows that 35% of organisations have increased employer contributions over the last year and 14% plan to do so in the next twelve months. However, Altman disagrees: "It’s quite clear that when employers are moving from DB to DC, they are taking the opportunity to cut contributions substantially in most cases."

But organisations often have more control over costs in DC schemes, something that is extremely important to pension bosses in the UK. And the type of scheme that best suits an employee often depends on factors such as age or position. An employee close to retirement would benefit from a DB scheme with a good accrual rate, while a younger member of staff, likely to move around jobs, would benefit more in a DC scheme with significant employer contributions.

And the advantage of a DC scheme often depends on the contribution rate. The aforementioned Employee Benefits research shows that only 5% of employers contribute between 11-20% of salary to their DC scheme. While compulsory employer pension contributions are often talked about, automatic enrolment is expected to be a more popular option. Altmann explains: "Compulsory pension contributions are not free. Employer contributions [must be] paid for, either in lower wages, lower employment levels and/or lower company profits."