The rise of defined contribution pensions

All information is correct as at 31 December 2021 unless otherwise stated.

Defined benefit (DB) pension schemes, once a mainstay of pension provision in the UK are on the decline. Private sector DB membership has plummeted 2.5m in the last decade alone.

People living longer means the cost of these schemes has soared. The fact most people change jobs more frequently means there’s little incentive for employers to keep ploughing enormous sums into a benefit the majority of employees are unlikely to be a member of for long. As a result, we’ve seen employers shutting up shop on their DB pensions. The only place DB pensions are still popular is in the public sector.

The rise of DC pensions

As DB schemes rapidly vanish from the private sector, they’ve been replaced by defined contribution (DC) schemes. Since 2012, lots of UK workers have been auto-enrolled into a DC scheme when they join a new employer.

Defined benefit members get a guaranteed income for life based on their final salary and how long they worked for the company. However, the success of DC schemes depends on how much is put into them and how well any underlying investments perform over the member’s working life.

This will then determine an employee’s final pension pot.

They’re not only much cheaper for employers to provide, they also free the employer from the long-term burden of providing a certain level of income to their employees. The responsibility shifts firmly from the employer to the employee. And this has enormous consequences for scheme members.

Why responsibility of your pension matters now more than ever

Many will have seen parents retiring with decent reliable DB incomes while not engaging with their pensions at all. They might have been members of DB schemes earlier in their career, but now after moving jobs, find themselves with a DC scheme they don’t know what to do with.

Members need to engage with their DC pension schemes. While auto-enrolment sets a minimum contribution level – currently 8% – this is well below what’s needed to generate a decent retirement income – members will need to do more.

When the government set these targets, there was concern people would assume these minimums would be enough to give them a decent retirement income. This has since borne out – average contribution rates for DC schemes remain at these minimums which are well below current DB contribution rates.

We found only just over a third of people knew their pension was an investment*. As we often talk about pension saving, rather than investing, there’s a sense that pensions are something more akin to a bank account than an investment. However, this means people are missing out on the opportunity to engage with how their pensions are invested and really help it grow.

While such a high level of inertia is understandable with a DB scheme where everything’s managed for you, it doesn’t translate to the increasingly DC world we live in. Engagement is vital. Even making small regular increases to contribution rates – for instance when you change jobs or get a pay increase – can really mount up over time and give your pension a huge boost.

*HL survey conducted by Opinium September 2021, 1,109 respondents.

The benefits of DC

To add to being able to make decisions on how much to contribute, DC members have unprecedented levels of choice around investments. Then when it comes to retirement, DC members have big choices to make about how they take their retirement income.

Since 2015, DC members have the choice of taking their income as an annuity, through income drawdown or even as a cash lump sum. They can even opt to use a combination of these options. This is different from what a DB scheme offers, which pays out an income for life.

The importance of engagement and what you can do about it

When the 2015 reforms were announced, there was a lot of concern that people didn’t have the right knowledge to make decisions around their retirement income. There were wild stories that people would blow their pensions buying Lamborghinis and leave themselves penniless in retirement.

However, people are taking a more sensible approach to their retirement. Though concerns remain about whether DC scheme members will have enough to see them through retirement.

Average pension sizes in the UK vary widely. The average UK pension pot is around £50,000 – way below what’s needed to generate a decent retirement income. Ideally, we’ll start seeing more auto-enrolment into pensions early in people’s careers, meaning average pension sizes should go up in the future.

The government recently announced its intention to encourage pension providers to nudge people towards guidance. This involves providers offering to book appointments at Pension Wise for people getting ready to take their income in retirement. These appointments will take people through their options and should help people make more informed retirement decisions over time.

These could be a game changer for engagement by increasing awareness of guidance services like Pension Wise and boosting how many people use them. Over time, initiatives like this should help plug the yawning engagement gap affecting DC pensions, but more still needs to be done.

This article isn't personal advice. If you're not sure what's right for you, ask for financial advice. Remember, pension and tax rules can change, and benefits depend on your circumstances. Once it's in, you can't usually take money out of a pension until age 55 (rising to 57 from 2028). All investments can rise and fall in value, so you could get back less than you invest.