There are 2 types of pension which an employee can be provided with from his employer- a defined benefit (DB) or a defined contribution (DC) pension. The 2 are very different. For American readers a DC pension scheme is the same as your 401k plans.
What is a DB Plan?
In the good old days most employers provided DB pension schemes for their employees. Typically, employees were then entitled to a proportion of their final salary when they retired, the amount they got was dependent on length of service. For example, a typical set-up would have been 1/60th of final salary for each year of employment. This would mean an employee who worked for a company for 40 years and enjoyed a salary of £40,000 would be entitled to a pension of £26,666 when he retired. I think you’ll agree that that is a pretty nice employee perk if you could still get it.
How is a DC Plan Different?
These days most DB schemes are no longer open to new joiners and most employees in the UK who sign up to an employee pension scheme will be signing up to a DC scheme. These are very less attractive beasts as the risks sit with the employee. The way they work is each employee is provided with a certain amount of pension contributions from his employer each month. Typically, if you contribute to the pension scheme yourself the employer will match up to a certain level your contributions. These contributions are then invested, normally through a life insurance company, into a set of investment funds which you will have chosen when you signed up to the pension. Based on the performance of the market,the value of your funds will go up and down and then when you eventually come to retire you will have a pot of money which will hopefully enable you to retire happily and contentedly with a nice pension income (please note- the rules regarding how you get an income from your pension pot are changing at the moment, how you go about doing this and what choices are open will be a topic for a later post).
Why are DC Plans Not So Hot?
1. In the UK you get tax relief on your pension contributions. This means you do not have to pay any tax on your pension contributions. The gimmick is however, that any income you do receive from your pension pot in retirement will be taxed. On top of this, given the state of some countries’ public finances taxes are likely to rise and hence you are likely to pay more in tax than you perhaps expected when making your retirement arrangements.
2. Make sure you know which funds your DC pension contributions are being invested in. I recently read an article which stated a third of people are on the default option, this means they are at the mercy of the “supposed investment expert” fund managers.
3. Look at the annual management charge which you will be charged to have your funds managed. Typically it can be anything up to 2%. These will massively cut into your returns if they are not minimised. One way of getting round these charges is to invest in index tracker funds, typically the management charge on these may only be about 0.5%. Tracker funds just match the market, for example you may have a FTSE 100 tracker fund which will just buy shares so that it matches the performance of the FTSE 100. Because these tracker funds do not require active fund management they’re cheaper to run.
4. One of my biggest gripes about DC pension schemes is that I do not think that pension investors are very well diversified. Yes, you can invest in shares throughout the world, in corporate and government bonds, and property shares but there are certain key asset classes which you can’t really get access too through a standard DC pension set up. These include commodities- yes, you can invest in commodity company shares, for example mining companies, but it is very different to actually investing in the underlying commodity directly such as copper or gold! As a result, I fear that although city fund managers claim they are investing in a diversified portfolio of assets, the reality may be that pension investors are not as well diversified as they may think. Consequently, a repeat of the 2008 financial crisis at a time close to retirement could be disastrous for some pension investors.
5. The government still has access to your pension funds, this should concern you a little. For example, during the 90′s Argentina and other Latin American countries suffered from a financial crisis, in the end to help bolster its coffers the Argentinian government seized the private pension funds of individuals. Given the dire state of the finances of some Western governments I would not completely rule this out.
Hopefully this article has cleared up the difference between DC and DB pensions and at the very least, if you are DC pension investor, opened your eyes to some of the issues.