My finances

Types of Pension

There are broadly two types of pension scheme:

The above types of scheme are given technical terms that you might have heard of but which often just confuse matters – "defined benefit" and "defined contribution". They were once referred to as "final salary" or "money purchase". Like me, you are almost on the point of switching off due to the impenetrable pensions jargon. But hang in there, you can get your head around all this.

Defined benefit/final salary

If you turn around the words "defined benefit" and add the small word "is", it might make more sense: ie a scheme where the "benefit is defined".

There are several variations on this theme and some have more certainty than others. They come under titles such as:

  • "final salary"
  • "career average revalued earnings" (or CARE),
  • "cash balance"

But in each case, one of the main features of these schemes is that there some sort of formula to tell you what to expect when you retire.

Defined contribution/money purchase

Let’s first address the jargon of "defined contribution". Adopting a similar strategy to above we get a scheme where the "contribution is defined".

Again there are several variations although the common design feature here is that the level of contributions is set out.

So in this type of scheme, you know:

  • what you have to pay
  • what your employer will pay on top of your contributions

However, you have to make some more decisions:

  • where to invest these contributions (see different asset classes)
  • what shape your pension will take when you retire

But you don’t know how well your investments will do.

While you will get statements each year trying to estimate what you might get when you retire, these estimates are not guaranteed, and the only thing we know is that the estimates will turn out to be wrong.

This does not mean these are bad schemes, it just means you need to take a more active involvement – and accept the final outcome might not be quite what you hoped for.

So which is best – I have heard that only defined benefit schemes are worth joining?

It is true that most defined benefit schemes in the UK are very good schemes, where the cost to the employer (which is not fixed) is often a multiple of 2 or 3 times what you pay (eg you might have to pay 6%), but it is likely that your employer will be paying 12-18% and may have to pay more if this turns out not to be enough to provide the pension that is defined in the rules.

Given how valuable these defined benefit schemes are, it probably comes as no surprise to find out that the number of employers in the private sector offering these schemes has fallen quite dramatically. Until about 10 years ago, nearly all FTSE 100 companies and many other private sector companies would have offered both current and new employees a defined benefit scheme. Nowadays, only a handful of FTSE100 companies offer these schemes to new employees, although many still offer them to existing employees.

These defined benefit schemes remain the norm for public sector employers (eg local government, NHS, civil service, police and fire services), although the generosity of the benefit at retirement has been scaled back somewhat over recent years to try and reduce the burden on the taxpayer.

So more and more employees in the UK are offered defined contribution schemes.

But despite the lack of certainty over your eventual benefits, most of these defined contribution schemes are still very worthwhile. While the precise details will vary from scheme to scheme, in most schemes the employer often matches your contributions up to a certain level. But whatever the design, if your employer is willing to pay even 1% into a fund for you, it must be worth having.

So the key message is – whatever pension scheme your employer offers – it is probably well worth joining it to get the value of the employer’s contributions.