As people live longer and healthier lives, it is important to plan ahead for retirement. For many people, this means putting money into a pension. This is a popular option for many as retirement plans often have tax benefits or are supported by employers. When considering the choices, it is important to be aware of what defined benefit and defined contribution schemes are and the difference between them.

Summary of Difference

· Defined benefit: As the name suggests, this scheme guarantees a certain fixed income to its members upon their retirement. Each member and his or her employer may make contributions, but they will in time be entitled to a periodic, set income.

· Defined contribution: This type of scheme is the alternative to the above method.

A member of this scheme makes agreed set contributions toward his or her retirement plan. There is no guarantee, however, of a definite income on retirement—the value of benefits paid out will by definition fluctuate.

Funding Pensions

With the growing number of retirees, the funding of pensions has become a controversial area and one that is more problematic for employers year after year. Over the last three decades, many employers have stopped offering defined benefit schemes to new employees or offering any pension at all due to the potential size of the issue.

Companies have seen the gap widen dramatically between liabilities owed in the form of fixed income owed to former employees, and the assets and income available to cover these outflows. Increasingly, defined benefit schemes are only open to employees in the public or state sector or those in heavily unionized industries. As a compromise, some companies have moved toward the defined contribution model. The company may make some form of matching contribution to the employee contribution, but there are no guarantees as to what this scheme will pay out.

Summary

Central to the difference between the two approaches therefore is who bears the risk for the pension scheme. Under defined benefits, the employer is left with the potential for a massive and perhaps fatal hole in its balance sheet. It is very difficult to accurately predict what resources will need to be allocated in the future for such a scheme. With defined contributions, the risk is removed from the employer. Frequently these schemes are administered by a third party specializing in pensions, which can add a further level of removal between employer and employee.