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What are defined contribution and defined benefit pensions?

You could have at least one of two types of pension, but both fund your retirement in different ways. Here is how a defined contribution and defined benefit pension works.

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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.

Defined contribution pension

This type of pension, also known as a money purchase scheme, is calculated by how much you pay into it during your life.

This means the more you pay in, the more you could get back when you retire.

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.

How do defined contribution pensions work?

You pay a percentage of your salary into your pension when you get paid, which is exempt from tax by the Government. Your employer may also offer to match your contribution, for example:

  • 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 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

If your employer offers to match your contributions up to a set percentage, such as 5%, then it could help boost your retirement income.

You can find different types of defined contribution pensions, including:

You can get guidance on how each defined contribution pension works by visiting the government's Pensionwise website.

Defined benefit pension

This is also known as a career average pension or final salary pension, and is usually a better pension type compared to a defined contribution scheme, as it guarantees a set income when you retire.

How do defined benefit pensions work?

When you approach your retirement age, your pension supplier will use the number of years you have paid into your pension and the value of your final salary to calculate your pension income, for example:

  • You retire on a salary of £45,000 and have worked with your employer for 40 years

  • Your employers' pension accrual rate, which is the proportion of your salary you get as a pension each year, is then applied, e.g. 1/60

  • Your pension income each year is then 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 employers' 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.

What is a cash balance plan?

It is a pension scheme that uses characteristics from both a defined contributions and defined benefit pension, and 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, like a defined contribution pension, which is 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 under perform.

How much do cash balances cost?

They do not cost you anything, however there could be management fees taken by your pension company, which covers the cost of managing the funds used in your pension.

Do you have to pay management fees?

If you want to manage your pension then you could take out a Self Invested Personal Pension.

Alternatively, some pensions offered through workplaces can be managed online, which let you change the level of risk taken with your pension fund.

Here is how to manage your pension

How much of an income could you get?

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 either type of pension.

You can usually start withdrawing from your defined contribution pension at age 55, or 65 if you have a defined benefit pension.

You can help ensure you have the retirement you want by finding the best personal pension plan to make your money work as hard as it can.