Defined contribution and defined benefit pension schemes / plans

There is a lot of discussion going on in the media about “defined contribution” and “defined benefit” pension schemes.

What exactly do these mean? What are their pros and cons? Is one better than the other?

In fact, the New Pension System / Scheme (NPS) for non-government employees is also envisaged to be a “defined contribution” scheme.

(Please read “Highlights of the New Pension System / Scheme (NPS) for non-government employees” to know more about the New Pension System / Scheme – NPS)

Let us understand what “defined contribution” and “defined benefit” mean, and see their differences, advantages and disadvantages.

Defined Benefit

In a defined benefit scheme, you know your pension amount before hand. Or, you know the formula based on which the pension amount would be calculated once you retire.

For example, even when you join service as a 22 year old, you would know that when you retire at the age of 58 years, you would get a monthly pension equivalent to your last drawn basic salary per month.

Since the pension amount is known, and is not dependent on any external factor or on any investment made by you, this type of pension scheme is called defined benefit pension scheme or plan.

Of course, for getting this defined benefit, you need to invest some amount periodically – say every month. Either you or your employer (or both) would contribute this amount.

This amount is invested and earns some returns. But irrespective of the kind of returns generated by the investment, you are assured of your pension as per the pre-defined formula.

This means that the risk of generating enough return lies with the employer.

Till some years ago, all government employees had “defined benefit” pensions. Their pension amounts were linked to their grade and last drawn salary.

Advantages of Defined Benefit Pension Plans

The main advantage of a defined benefit scheme is that – as you would have guessed – the benefit or the pension amount is defined, or known beforehand. This gives a lot of peace of mind.

And you get this pension, no matter how the investments fare. So, you do not have to worry about how the investments would perform. And you do not have to monitor the investments periodically and make adjustments (for example, shifting from equity investment to government securities).

Disadvantages of Defined Benefit Pension Plans

As an employee, there is no apparent disadvantage of the defined benefit pension plan.

However, there are disadvantages for the employer. The employer has to ensure that the funds contributed for the pension are invested in such a way that they generate adequate returns to cover future pension of the employee.

And this is often quite difficult – a prime example being the government’s pension scheme for its employees.

In that case, the returns were not enough to cover pension of the employees, and the government either had to provide for the pensions from other sources of revenue, or from the pension contributions of serving employees – the amount that should have been invested for their pension!

Defined Contribution

In this type of a pension plan, the pension amount is not known beforehand. Also, there is no fixed formula based on which your pension would be determined.

Instead, this is what happens: You keep contributing the amount towards your pension throughout your working life. The amount is invested on your behalf, and the pension that you get after retirement depends on the returns generated – the final corpus of your retirement fund determines your post-retirement monthly pension amount.

This means that the risk of generating enough return lies with you, and not your employer.

Since the amount that you contribute towards your pension is fixed but the pension is not, this is called defined contribution pension scheme or plan.

The New Pension System / Scheme (NPS) for non-government employees is going to be a “defined contribution” scheme.

(Please read “Highlights of the New Pension System / Scheme (NPS) for non-government employees” to know more about the New Pension System / Scheme – NPS)

How “Defined Contribution” works

Flexibility in investment

Since your pension depends on the returns made on the investments, you usually get some say in the way in which the amount is invested.

There can be multiple options available – like equity focused (high risk, high possible returns), debt focused (low risk, low possible returns) or anything in-between (medium risk, medium possible returns).

You usually get the ability to distribute your funds among these different options. Also, you have the ability to change this allocation periodically, say once every year or once every 6 months.

Annuity at the time of retirement

At the time of your retirement, your contributions and the returns generated through their investment over the years would have grown into a large amount.

You are allowed to withdraw only a portion of this amount as a lump-sum. This can be say 30% or 40% of the amount (The exact proportion of the amount allowed for withdrawal depends on the pension scheme).

With the remaining amount, you buy an annuity. This annuity would provide you a fixed amount every month, which would act as your monthly pension.

Advantages of Defined Contribution Pension Plans

The main advantage to you as an employee is that the pension is market-linked: the pension amount depends on the amount with which you buy the annuity, and this amount in turn depends on the returns generated over the years.

Through proper allocation of your funds during your working years, you can make excellent returns on the investments, which would mean that you get a great monthly pension.

The advantage for the employer is that it doesn’t have to worry about management of the pension funds and the returns generated by them.

Disadvantages of Defined Contribution Pension Plans

Unfortunately, the fact that that the pension is market-linked can also be a disadvantage if you are not prudent in your allocation of funds between different investment options.

If the returns generated are not enough, you would get a low pension – meaning that you would be forced to have a low standard of living during your retired life.

Therefore, proper allocation of funds between different investment options based on your risk profile is extremely important for defined contribution pension schemes.

(To learn more about risk profile and how to find your risk profile, please come back to read “Understanding your risk profile”)

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