Defined benefit and defined contribution pensions
While most of us think of pensions as a singular thing, the truth is that there are many different types of pensions. If you work for a company you are usually offered one of two employer-sponsored pension plans – defined contribution plans or defined benefit plans.
While their names may make them sound complicated, they are quite straightforward once you understand what makes them different.
Over time, defined contribution plans have become the more popular type as the employee (rather than the employer) bears the investment risk and administration costs, saving businesses money.
This article will help you understand the two different types of pension and the pros and cons of each.
What is a Defined Benefit pension?
A defined benefit pension is a scheme that pays out a secured income for life which increases each year. It is also sometimes known as a final salary pension.
The investment risk and admin costs are the responsibility of your employer. Unlike a defined benefit plan, you don’t have control over the fund and there’s much less flexibility.
With this type of plan, an employer usually continues to pay your pension to your spouse, civil partner or dependent if you pass on.
How much will I get?
Your pension pot from a defined benefit plan is based on three criteria:
- Pensionable service - the number of years you’ve been a member of the plan
- Pensionable earnings - usually your final salary or your salary average
- Accrual rate - he proportion of earnings you’ll receive as a pension for each year in the scheme.
Calculating your pension income
Is my defined benefit pension protected?
Most pension schemes are usually run by pensions providers rather than your employer, meaning that you will not lose your pension if your employer goes bust.
If the pension provider goes bust you will be compensated by the Financial Services Compensation Scheme providing the pension provider was authorised by the Financial Conduct Authority.
What if I leave the scheme?
When people leave a job with a defined benefit pension scheme, most choose to keep it and collect it at retirement age.
You might think about transferring the money out of the scheme, but in many cases you will be worse off. It is strongly advised that you talk to a regulated financial adviser if you want to consider this option.
Taking a lump sum from a defined benefit pension
Some defined benefit plans will let you take the whole pension as a lump sum. 25% will be tax free and you will have to pay Income Tax on the rest of the amount.
You can take a lump sum once you are over 55 as long as the total value of your pension savings is less than £30,000.[i]
What is a defined contribution pension?
A defined contribution scheme is a workplace pension that’s built up through contributions from you, your employer and Government tax relief. The amount each party pays depends on the type of scheme your employer has enrolled you in.
When you reach retirement age, your pension pot value will depend on the contributions made over time, the return on investment and the deduction of fees and charges. This means that unlike a defined benefit pension, this type doesn’t promise a specific income at retirement.
How are contributions made?
Contributions are made every month by you and your employer. Your contribution is normally taken from your salary before tax, essentially giving you more money to put into your pension pot.
You can use the Money Advice Service’s pension contribution calculator to find out how much you and your employer will pay into your defined contribution scheme.
What’s auto enrolment?
From 2012, you will have been auto-enrolled to a workplace pension as all employers have to provide one. You will be enrolled as long as you meet all of the following criteria:
- You are a worker for the company
- You earn more than £10,000 a year
- You are aged between 22 and retirement age
- You normally work for the business in the UK (the Government has more guidance about this if you’re not sure).
There are a few instances where an employer doesn’t have to enrol you in this type of pension. You can read about those conditions on the Government website.
What are my options once I turn 55?
You can draw your pension however you decide is best once you turn 55. The options are:
Take a single lump sum - the first 25% is tax free and you will pay Income Tax on the rest.
Take multiple lump sums - you can choose to take smaller lump sums as and when you need. The same tax rules apply.
Take a quarter and income - you may want to take the 25% tax free and use the rest as a source of regular taxable income.
Take a quarter and get an annuity - you can take 25% tax free and convert the rest into retirement income.
What if I change jobs?
If it’s time for a change and you move to a new place of employment you might be able to leave the pension where it is. These are called deferred or preserved pensions.
You can also transfer your pension to a new employer, or to a stakeholder or personal pension, but there are risks and costs that come with this option. A stakeholder pension is a type of defined contribution personal pension. You can find out more about stakeholder pension at Money Advice Service.
Being aware of pension scams
Any decision you make about any pension should be made with great care. Pension scams can trick even the most savvy people out of their life savings.
Inform yourself on the subject, find independent financial advice and always look out for the warning signs like:
- Cold calls
- Promises of high returns
- Unusual investments
- Unusual phrases
- Long-term investments
- Complicated systems and processes.
If you would like to read more about pension scams or think you may have been affected, the Government offers consultation on pension scams.
Considering financial advice
As with any big financial decision in life, you may think about getting financial advice from a financial expert. An independent adviser could help you make informed decisions about your pension pot that could help keep you safe and make the most of your money.
The Pensions Advisory Service can help with anything questions you might have about defined benefit or defined contribution pensions.
Learn more about how pension drawdown works.
The information on this page was sourced between June - October 2020. Information on this site does not constitute any form of advice, representation, or arrangement by us and you take full responsibility for making (or refraining from making) any specific investment or other decisions. You should take independent financial advice from an adviser who is registered by the Financial Conduct Authority.