Defined Benefit vs. Defined ContributionEasy

Two entirely different machines share one word. In the first, somebody owes you an income and has to find it; in the second, you own a pot and it is worth what it is worth.

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One word, two machines

• A defined benefit scheme promises an income. A formula — years of service, a salary measure, an accrual rate — produces a payment for life. The sponsor's job is to make that payment happen, whatever the investments did.
• A defined contribution scheme promises a payment in. A percentage of pay goes into an account, it is invested, and at the end it is worth whatever it is worth. Nobody has promised the outcome, and nobody is on the hook for it.
• Almost every confusion about pensions starts here, because both are called a pension and the word conceals which of the two somebody has. How a pension actually works is the plain-language version; this is the comparison.

The question underneath: who carries which risk

• Investment risk. Under defined benefit it sits with the sponsor: the promise is fixed and the assets have to reach it. Under defined contribution it sits with the member, entirely and without a buffer.
• Longevity risk — the risk of living a long time, which is a risk only in the arithmetic sense. Under defined benefit the scheme pays until you die, so it carries it. Under defined contribution the pot runs out when it runs out, unless it is used to buy an annuity, which is precisely the transaction of handing longevity risk to an insurer.
• Inflation risk. Under defined benefit it depends on whether the promise is index-linked and on what cap applies — a real question with a documented answer. Under defined contribution it is the member's, and it is the risk least visible in a statement showing a number in today's money.
• Sponsor risk. Under defined benefit the promise is only as good as whoever made it, which is a risk defined contribution simply does not have: a pot already belongs to the member.
• Read as a whole, the trade is legible: defined benefit removes three risks from the member and adds one; defined contribution does the reverse.

Why one is a balance-sheet problem and the other is not

• A defined benefit promise is a liability of the sponsor, and a long-dated one. Its value is the present value of payments decades out — so it moves with the discount rate, which means a fall in long yields increases what the company owes without anybody doing anything.
• Which is why the assets are invested to move with it. Matching a liability that behaves like a long bond means holding things that behave like long bonds, often with leverage to get enough sensitivity from a smaller pot. LDI in 2022 is what happens when that hedge is right and the funding of it is not.
• A defined contribution pot is not the employer's liability at all. The contribution is an expense when paid and the story ends there, which is most of why the corporate world moved from the first to the second.
• The rest of that move is longevity. People living longer makes a defined benefit promise more expensive every year, by arithmetic, without anybody deciding anything — see the pensions seat.

What happens if it goes wrong

• Defined benefit, sponsor fails — the scheme is a separate trust, so the assets are not the employer's creditors' to take, and in many jurisdictions a protection fund pays a reduced benefit above a floor. The member's risk is a haircut rather than a wipe-out, and the terms are statutory.
• Defined contribution, provider fails — the assets are held separately from the provider and belong to the member. The failure mode is not the provider going under; it is the markets, which is a risk nobody insures.
• Both structures separate the assets from the firm, and for the same reason as every other arrangement on this site that works: the party making the decisions is not the party holding the money. How a fund is built is that argument in full.

The comparison

The one row worth sitting with

The last one. A defined benefit member knows what they will receive and not whether the promise is funded; a defined contribution member knows exactly what they have and not what it will buy. Each structure hides precisely the thing the other shows, and no statement from either kind of scheme resolves the half it is silent about.

That is a description of two structures rather than a judgement between them, and it is deliberately where this page stops: which arrangement suits a particular person depends on facts about that person, and this site does not know any of them.