There are several kind of pension plan systems:
DB: Defined Benefit
- These pension plans provide guaranteed pension terms at pension age. There is no investment/ interest rate risk. These plans often also have a conditional right to indexation in order to correct for inflation.
- DB can be based on the actual Annual Wages. In case it is based on the Final Wages every wages increase creates a substantial premium back services as it also works towards the past employment. These aspects make these plans extremely expensive as the interest rate is historically low.
- DB plans were popular in Europe but have as of 1995 often been exchanged rapidly for DC pension plans.
- It is expected that in the near future final wages DB systems will be prohibited in several countries.
DC: Defined Contribution
- These pension plans provide guaranteed amounts of pension premium. At pension age an annuity will have to be bought with the total pension capital. There are no guaranteed pension terms. There is a substantial investment risk until pension age and a substantial interest rate risk at pension age.
- The investment risk might be mitigated by good Life Cycle funds which automatically decrease the risk as the age increases.
- The costs and performance of investment funds are highly relevant for DC systems. In certain countries like Holland there are new totally IT based providers who excel in low costs and high flexibility.
- In certain countries like Germany a pure DC system is not allowed and there is a modest guarantee to protect participants.
- In certain countries like the UK it is as of 2015 allowed to completely drawdown the total capital as of age 55 and even have a 25% non-taxation.
- In certain countries like Holland it is allowed to within DC partially keep investing pension capital as of pension age. The risk profile has to focus on the period before and after pension age.
CDC: Collective Defined Contribution
- In this system with the DC guaranteed amount of pension premium guaranteed amounts of pension annuity are acquired. In case the premium is not sufficient to provide the desired amount of annuity, then the latter will be decreased to a lower and affordable level.
- It is called the best of both worlds but as the interest rate is currently historically low, one can wonder if the price for certainty is not (way) too high.
- A hybrid system has DC/DB/CDC elements. A popular hybrid system is to have a DC system for the old age pension coverage and a DB system for the next of kin pension coverage.
Trend in Europe
- The trend in Europe is towards more individual and DC based solutions.