Most people have either a defined contribution or a defined benefit pension, but do you know which is which and understand the difference between them? Here’s what you need to know.
Pensions are long term investments. You may get back less than you originally paid in because your capital is not guaranteed and charges may apply.
If you’ve got pensions savings outside of the state pension, they’ll either be defined benefit (DB) or defined contribution (DB). Both kinds have the same tax benefits when saving for retirement, but there are big differences in terms of what you’ll get out at the end. Here we explain the differences between them, and how to work out which kind you’ve got.
If you’ve been auto-enrolled into a workplace pension, it’s likely to be a defined contribution (or money purchase) scheme. In fact, these arrangements are the most common workplace schemes in the private sector. Equally, if you’ve set up a private pension, such as a SIPP, that will be DC too.
The main characteristic of these schemes is that how much you get when you retire depends on how much you pay in during your working life and how well your investments do.
This means the more you pay in, the more you could get back when you retire. Equally, saving while you’re young means your money will grow more quickly thanks to compound interest over time.
Your money will be invested in a mixture of cash and stocks and shares investments, so you could end up with less than you put in based on their performance.
If you’re saving into a workplace scheme, you pay a percentage of your salary into your pension, which also gets tax relief at your marginal rate. You pay in a minimum of 5% of your salary (including the tax relief) and your employer pays in at least 3% on top. Some employers may also offer to match higher contributions up to a limit. This is a great way to boost your savings and get free money from your employer.
An example arrangement might be:
You earn £20,000 a year
You contribute 5% to your pension (£1,000 each year), which is taken from your pay before income tax or National Insurance is deducted
Your employer also contributes 5% (£1,000 each year), without any income tax deduction
This means you could have a combined contribution of £2,000 paid into your pension each year tax-free
You can decide to save more even if your employer won’t match – and you’ll still get the tax relief from the government.
If you’re saving into a private pension, there’s no employer, so you won’t get extra contributions there, but once again you’ll get the income tax relief bonus.
There are several different types of defined contribution pensions, including:
Group personal pension
You can get guidance on how each defined contribution pension works by visiting the government's Money Helper website.
Defined benefit pensions are also known as a career average pension or final salary pension. While they used to be common in the private sector, most companies have now closed their plans. These pensions are still common in the public sector, for instance for doctors and civil servants.
The reason these pensions are so valuable is because what you get depends on your salary and length of service rather than your contributions and investment returns. You get a guaranteed annual income for life that is usually much higher than defined contribution savers can hope to achieve.
Your pension provider usually uses either your final salary or an average of your salary over your career to work out how much you get. The precise rules and calculations will be set out in your scheme rules.
A typical example might be:
You retire on a salary of £45,000 and have worked with your employer for 40 years
A pension accrual rate of 1/60th for your company’s scheme (pension accrual rate is the proportion of salary you get as a pension for each year you work).
Your pension income is calculated by taking your final salary (£45,000) and dividing it by 60 to make £750.
This figure is multiplied by the number of years you have paid into your employer’s pension to generate your annual pension income; £750 x 40 = £30,000 a year.
Some companies take the average salary from your career to work out your pension instead of your final salary.
A cash balance plan has characteristics from both a defined contribution and defined benefit pensions. It works in the following way:
Your employer guarantees you an income when you retire, like a defined benefit pension
You and your employer contribute to the pension fund, and these contributions are invested on your behalf by a board of trustees
If the investments outperform the amount your employer guaranteed to pay you, they could give you a higher income, but this is down to their discretion
Usually, your employer keeps any extra to one side so they can top up the pensions of future employees should their pension fund investments underperform.
If you have a defined benefit pension, your scheme should tell you what your projected annual income is. This income will rise each year of your retirement in line with inflation.
Defined contribution pensions are less easy to predict as investment incomes are not certain and your pension company doesn’t know how much you’ll contribute over the years. Generally, experts tend to say that a pension fund investment should return around 3%-5% over the long term, but of course, it could perform over or under this figure.
You can use the pension calculator on the Money Advice Service website to see how much of a retirement income you could get from the amount you save into all your pensions. It lets you add multiple pensions and even includes your state pension entitlement.
You can usually start withdrawing from your defined contribution pension at age 55, though this is due to rise to 57 from 2028. Defined benefit pensions have different access ages depending on the scheme rules, but 60, 65, or state pension age are all standard.