There are two types of pension plan – defined contribution and defined benefit. The former is more common in the private sector because it allows an employer to make a fixed contribution to an employee’s pension pot, usually a percentage of their salary. When the employee retires, that pot is usually turned into an annuity (an income stream), the value of which is determined by the market.
With a defined benefit plan, on the other hand, an employer bears much more risk and also cost. That’s because the employee is guaranteed an income in retirement, calculated as a percentage of their final or average earnings. The employee still makes a contribution from their salary but this does not directly affect the size of their final pension. Due to people living longer and poor recent stockmarket performance, this type of scheme is being phased out by companies. The other main provider, the government, is also looking at ways to reduce the cost to the taxpayer.
• See Tim Bennett’s video tutorial: A beginner’s guide to pensions.