Defined benefit versus defined contribution pension

[DogDaysNeverEnd]

I've scoured the internet but I can't figure out how to compare a defined benefit and defined contribution pension scheme.

I've just joined the university USS pension at age 42. I have to pay about £300 per month, and I think will see £450 per year pension for each year of contributions. The current strike action is about pensions, amongst other things, so it got me wondering; how does this compare to if I was putting the same into a private pension? I don't have a choice with work, but as university pay is also not stellar I'd like to be able to compare jobs with the two different schemes to know what is a "good deal".

If anyone can shed some light I'd be most grateful.

in all pension schemes there is a risk involved because you put your contributions in when you don't know what the economy is going to do over the next few decades, or what the world will be like when you retire.

in a defined benefit scheme the risks are ultimately borne by the employer, with the costs spread amongst all contributors into the scheme. so when you pay your £300 in you know that basically each month you are a member it increases your retirement income by a known amount. the pension scheme are obliged to keep their promises to you on this, and if there's not enough money in the pot to meet their obligations they have to increase the contributions of future members to keep it balanced.

in a defined contribution scheme the risk is all borne by the individual. instead of knowing that your £300 now will definitely increase your weekly pension in a few decades time by £X, you are at the mercy of the peaks and troughs of economic growth. if you are unlucky that £300 may only generate half of the £X you might have got in a DB scheme, but if you are lucky and the economy booms at just the right time, you might get £2X instead.

The major problem with USS at the moment is that a health check of the investments held and income from those investments and expected income from members who are currently still working, vs current obligations to those who have already retired and future liabilities when existing members retire, came up with a raft of numbers saying basically there's not enough money flowing through and we have to either increase contributions or reduce expected benefits.

however that was relying on calculations based on the longest period of low interest rates ever and a generally sluggish economy, with various pessimistic assumptions. the same sums could be done with different assumptions and show that actually there's plenty of money. As no one has a crystal ball there's no way to know which forecast is correct.

if existing terms are kept and then the economy thrives, the scheme's investment holdings pay healthy dividends and the government maintains investment in the sector so that there are plenty of new members in the system to add their own contributions to the pot, then there will be no problem.

if, as the employers fear, the economy continues to struggle and there's not a lot of investment income, and budget cuts mean the whole sector shrinks so there are fewer new members paying in, then sooner or later the whole scheme could get to a point where obligations/liabilities far outstrip their assets and income with no hope of rebalancing, and the scheme goes bust. all pension schemes are obliged to make assessments of the likelihood of this happening, and take early steps to prevent it if it seems possible.

in the case of uss a lot of the members are really quite good at economics - and those who don't specialise in economics are intelligent enough to understand the rationale explained by those who do, and are quite cross that one fairly arbitrary forecast is allowed to be chosen and championed by the employers as if it was a reliable prediction.

Thanks, that's helpful. So basically defined contribution is always a best guess.

I found an online calculator that said £300 per month for 20 years would be worth around £100k at the mid range performance. So a £100k pension pot verses £9000 per year pension...

Now, if I had that £100k can I work out what that would generate for a pension. Is that about buying an annuity?

Quite clueless about all this but very aware I need to start paying more attention!

I think annuity rates are around 3% so the USS offers much better value

how old are you?
the younger you are, the better chance there is of DC being not too bad in the long run.

if you are 30 years old, then £300 self-invested in a defined-comtribution pension only needs to yield a 3.5% return on average each year to equal the performance of a defined-benefit scheme. on average over decades the global economy tends to grow so while there may be peaks and troughs that's not a ridiculous expectation

if you are 50 you would need your defined-contribution investment to reach about 5% return on average to get a similar benefit, and you would need some quite heavy rose-tinting on your spectacles to rely on that, though it's not impossible.

I would generally grab a DB opportunity with both hands and be grateful, but I wouldn't invest any extra into their options for buying additional years membership as those are priced a lot less favourably than your standard accrual of membership. better to spread your investments into other savings products.

Employer contributions to USS are enormous so I would absolutely take advantage of that if I were you. You won't get the same value from paying into a private pension, or anything like it!

oh sorry I see your age is in the op
Yes stick with the DB scheme

Enormous, but largely irrelevant for comparison because the DB is what OP will get.

OP, I think you are on below £40k and therefore below the cap. This is good.

By the way, you do have a choice to opt out of paying pension contributions, but then the employer would not pay theirs either.

Not irrelevant at all. It is the huge employer contributions which enable the defined benefits to be paid at the rate they are.

You would have to contribute an awful lot to a private pension to be able to match that.

Thanks, it's getting clearer. What's the significance of exceeding the cap? If I stick with this job I hope that I do in a couple of years. I can see there is the other scheme that is the defined contribution part. Is that not great?

I have some pension but I worked overseas for 10 years and self employed, plus years doing a PhD may not have been the best financial decision I ever made (don't regret it though!). Now I want to know if I'm playing catch up or things are ticking along. I'll see and advisor when I can but I'd like to have a better idea of what's what before I do.

@FeinCuroxiVooz I read an interesting article about the pension in comparison to those for teachers, post-92 uni staff and LA employees showing how the USS had been devalued. That looked pretty rough, and explains why USS members are disgruntled. I feel quite bewildered by it all. Where I worked previously it was all defined contribution and I never had to think about it too much.

@DogDaysNeverEnd make sure you will have sufficient years for your state pension. www.gov.uk/check-state-pension

The rule of thumb is DB schemes are generally better than DC schemes.

I wouldn’t worry about the annual contributions cap. You would need to be earning enough to afford for £40,000 a year of your salary to go into a pension before it becomes an issue. As you are paying in £3,600 a year at the moment this seems unlikely.

There’s another cap called the Lifetime Allowance (known as the LTA). This is £1,073,000. That figure usually (but not always) goes up with inflation each year. That is the biggest your pension pot can grow to before there is a punitive tax on the excess. For DB pensions with a guaranteed annual pension, the value for the purpose of the LTA is to take the amount that you will receive as an annual pension and multiply it by 20. So a £10,000 a year pension is equivalent to £200,000 when tested against the LTA.

Nearly always a DB pension is better than a DC pension. The employer takes the risk and there is often a pension for your spouse if you die. Most DB pensions have disappeared as unaffordable for the employer nowadays.

I think @SheilaFentiman was refering to the USS DB cap, which means the portion of contribution for salary over £40k or thereabouts goes into a DC scheme, rather than increasing the DB element.

USS is far better than a DC scheme. £100k pot gets you about £3-4k income.

I'll get enough years for state pension, but a good reminder thanks! I paid in as self employed but didn't have a personal pension for several years as I was only scraping by.

Sorry, yes, I was!

At salaries below £40k, all contributions mean you accrue at 1/85th (worse than it used to be) and so you don’t need to think about the performance of funds in the DC part of the scheme, or how much actual money from your contributions and theirs is going into this bit.

USS has got worse in accrual rates and treatment of inflation and DB caps, but the DB cap doesn’t affect you, so that is one part that has stayed them same for you, effectively.

I do agree with PP that opting out of the scheme and putting your £300 pcm otherwhere would be unlikely to build a pot that paid as much as the USS forward projection.

Thanks for all the responses, I'm picking it up. I'm not thinking of opting out, I really need to be topping up if anything. I'm on a temp contract at the moment so if that gets made perm I'll decide if it's worth adding extra via salary sacrifice or paying into something else. If the job does continue I'd reach the DB cap in a couple of years, so I need to think about the DC element too, not sure if that's optional.

What I'm really not sure of is comparing apples and pears, of say private sector work with higher salary but lower and more volatile DC pensions. I'd like to say "oh it sorts itself out" but it clearly doesn't and I need to think about my options.

“If the job does continue I'd reach the DB cap in a couple of years, so I need to think about the DC element too, not sure if that's optional.”

I’m afraid it isn’t!

We all contribute 9.8% of salary at all salary levels to the USS scheme, and the employer contributes 21.6%, and then the contributions are used to fund current retirees and future pensions, on the basis of the rules in place for each group. With the DC part, you can see in the USS website what has been attributed to you and you can make a (limited) selection of funds (normal, environmental etc) but not as much as in a private pension.

If you earn over the cap then your contibutions stay the same but instead of accruing additional DB pension there is a contribution to the DC part of the scheme (investment builder?). This amounts to 20% of your salary above the cap going into the DC scheme. i.e. if you are paid £50k a year you will accrue 20% of £10000= 2000 in the DC part of the scheme. You can adjust which fund this goes into online.

20% is a lot but it mignt seem confusing given that you are paying in 9.8% and the employer over 20% of your salary to the scheme. That's because a very large chunk of the employer's contribution is going to the deficit and not to your personal pension pot.

Sorry just to be clear when I say contibutions stay the same in my previous email I mean that the percentage stays the same i.e. you pay in 9.8% regardless of whether you are under or over the cap. Obviously the actual amount will increase the more you earn.

“20% is a lot but it mignt seem confusing given that you are paying in 9.8% and the employer over 20% of your salary to the scheme. That's because a very large chunk of the employer's contribution is going to the deficit and not to your personal pension pot.”

thanks, Mia, I hadn’t seen it broken out like this before.

Yes above the salary threshold it is extremely clear that the very large employer's contributions are not an accurate reflection of the benefit to you as an individual - at that point more than half of the employer's contribution is going to the health of the scheme and not your 'pot'.

The examples here show how it works - see 'Sarah' who earns over the salary threshold for the calculation www.uss.co.uk/for-members/youre-a-new-joiner/what-youll-pay

For annuity rates have a look here:-

www.sharingpensions.co.uk/annuity_rates.htm

I would expect USS to provide a spouse’s pension and have escalation so I think that you would get £4933 your £100k.0