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What is the difference between salary-related and 'money purchase' schemes? Which is better?
Salary-related, defined benefit or final salary schemes make a pensions promise – i.e. the 'defined benefit' – to members. In other words, you can work out how much pension you will be paid in advance. Normally this is based on your salary when you retire and how many years you have been a member of the pension scheme. This particular case is known as a final salary scheme, but other ways of working out your pension are used by some schemes, such as your average salary over a number of years.
- how much you and your employer contribute – i.e. the 'defined contribution' – to the pension fund;
- how well the pension fund’s investments perform; and
- annuity rates when you retire.
Both kinds of scheme can be used by an employer for auto-enrolment provided that they meet certain minimum standards, but many employers including those that previously had no workplace pension scheme are choosing to use money purchase schemes.
The basic difference between salary-related pensions and money purchase schemes is that with a salary-related scheme you can tell in advance what pension you will receive, while a money purchase scheme pension will depend on factors that can't be predicted in advance, such as the performance of scheme investments and annuity rates. Another way to look at this is that with salary-related schemes the employer bears the risk. You have been made a pensions promise, and it is up to the employer to make good that promise by paying enough into the scheme.
The downside is that some employers default on their pensions promise (for example, because they have gone bust). Many people have lost a great deal from this. In response, the government introduced the Pensions Protection Fund that will help people who lose in this way by paying most of their pension.
With a money purchase scheme, you bear the investment risk. If investments do badly, or the arrangements you make for turning your pension pot into an income (such as an annuity) are unfavourable, then you will end up with a lower pension. You may also have to pay management charges that can make a real difference to your pension income over time. On the plus side, because you build up your own pensions pot and your pension does not depend on future employer contributions to meet a promise, it is safer if your employer goes bust.
This does not mean that a salary-related scheme will always pay a better pension, or that salary-related pension schemes are always better. For the same contribution rates over some periods, a good money purchase scheme may provide a better pension than a typical final salary scheme. There are good and bad examples of both types of pension (and many people who would be grateful to have access to either!).
One of the biggest issues you will need to think about is how much is being saved into the scheme by your employer and by you. Many employers have replaced salary-related schemes with money purchase schemes in recent years, but have also cut back the employer contribution at the same time. On the whole, salary-related pension schemes are likely to pay a better pension than money purchase schemes, but it does not mean that every salary-related scheme is better than every money purchase scheme.