A review of the risks, costs and benefits of defined contribution and defined benefit pension schemes

Abstract

PurposeThe purpose of this paper is to evaluate the relative risks and benefits associated with defined contribution (DC) and defined benefit (DB) pension schemes. New regulatory and governance requirements and demographic changes have all significantly raised the costs and reduced the expected benefits to employers of operating DB schemes. In response, many employers have either closed down their DB schemes, closed the scheme to new members and/or to capped any further accruing of benefits for existing members. This decline in DB schemes and their replacement by less generous DC schemes, has been overwhelmingly seen by employees, the general public and Government as an unwelcome development that shifts significant pension risks from the employer onto the employee.Design/methodology/approachThe paper evaluates claims that DB schemes are less risky than DC schemes and, whether their passing ought to be such a cause of concern.FindingsThe paper finds that DC schemes are not inherently riskier than DB schemes. Indeed, it is argued that the low operational, governance and regulatory costs and flexibility of DC schemes provide employers and employees with the most cost‐effective means of saving for a pension. In contrast, despite the appearance that the employer rather than the employee is the primary risk bearer in respect of DB schemes, it is shown that this is largely a fallacy. Such an arrangement merely substitutes an employer's covenant for some portion of an independent (of the employer) investment portfolio. This reliance upon an employer's promises to continue to support and fund the pension scheme imposes a raft of additional firm‐specific (i.e. non‐diversifiable) risks and regulatory and governance costs upon the members of both DB and DC schemes.Originality/valueThe paper provides a topical and useful review of the risks, costs and benefits of DC and DB pension schemes in the UK.