Defined contribution vs defined benefit: how your pension scheme impacts your retirement

Pensions are a crucial savings tool for your retirement, but the type of scheme you choose will influence how your pot is managed and ultimately how you access your cash in your golden years.

Most people are in defined contribution (DC) schemes, where you and the business you work for both contribute. The scheme chooses fund managers and aims for a decent long-term return from the stock market to help your money grow.

People working for larger companies may have access to a defined benefit (DB) scheme, something which is also very common in the private sector. These operate differently and typically provide a retirement income based on your average or final salary.

Both types of pension can affect your retirement planning in different ways.

Here, Telegraph Money explains what you need to know.

• What are defined contribution pension plans?
• Types of defined contribution schemes
• What are defined benefit pension plans?
• What are the key differences?
• Should I transfer from a defined benefit to a defined contributions scheme?
• Pros and cons of each scheme

What are defined contribution pension plans?

A DC scheme, sometimes known as money purchase, means the value of your pot will depend on how much you put in and its performance on the stock market.

Contributions earn pension tax relief from the Government, based on your marginal rate.

The money you pay in is then managed by an asset manager, who invests it on your behalf and hopefully helps you build a substantial pot for when you retire.

The total you end up with will depend on how much has been contributed, the fund charges and stock market performance, making it hard to predict.

Types of defined contribution schemes

There are two main types of defined contribution schemes.

The most common is a workplace pension and since 2012, employers have had to automatically enrol any staff who are:

• classed as a worker
• aged between 22 and state pension age and
• earning at least £10,000 a year.

Under auto-enrolment rules, employers and employees pay a minimum amount into a workplace DC pension scheme.

This is currently 8pc, divided into 5pc from the employee and 3pc from the employer. This is just a minimum and either, or both, can put in more.

Employees receive tax relief at their marginal rate, so a £1,000 contribution would cost a basic rate taxpayer £800, with the remaining £200 added by the Government. Higher rate and additional rate taxpayers would pay just £600 and £550 respectively, as they receive higher tax relief.

The other option is a private pension. The most common is a self-invested personal pension (Sipp), which are offered by investment platforms and asset management companies. You can either manage this yourself and make investments, or pay a bit more for someone to do it on your behalf.

You won’t normally receive employer contributions (unless you have an agreement with your employer), but you will still get tax relief.

There are also stakeholder personal pensions, which offer ‘simple’ investment plans with low and flexible minimum contributions, low charges and a more limited range of investment fund choices.

What are defined benefit pension plans?

A DB plan is more commonly found in the public sector. They’re still offered by large companies, but this is becoming less and less common due to rising costs.

Rather than relying solely on contributions, this scheme defines a guaranteed income that you will be paid when you retire.

There are a couple of ways this calculated. A final salary pension determines a level of income based on how much you earned when you retire or leave the scheme. You accrue a percentage of entitlement each year and this is usually applied to your final salary, generating a lifelong income. This is becoming less common and has been all but removed from the public sector.

“Career average” plans, which are common in the public sector, mean a percentage of each year’s salary is deposited into a pot, which then grows each year with inflation.

DB plans are a bit easier to predict because they will provide a guaranteed, inflation-linked income for life.

What are the key differences?

The main differences are how money goes in and how it comes out. Both are invested, receive pension tax relief and are mostly provided through your employer. In most cases, you won’t really get a choice of scheme.

The most common type of pensions nowadays are DC schemes, unless you work in the public sector.

In a DC plan, both employee and employer contribute to an account. The investment risk sits solely with the saver, and the value of the pot when you come to retire will depend on how much was put in and how well it was invested.

There is no guaranteed income in later life. Instead, when you come to retire, you can choose to access your pension through drawdown or by taking an annuity.

In contrast, an employer is legally responsible for funding a DB pension scheme, so the saver is guaranteed a certain amount when they retire based on either their final salary or a career average.

If the employer goes bust, the pension is guaranteed by the Pension Protection Fund. This protects 90pc of the expected pension payouts for current workers, and 100pc for those already retired. However, these pensions can still be eroded by inflation due to the fund’s rules.

The table below shows how the two pension types compare:

Does a defined benefit pension provide lifelong benefits?

A DB scheme provides a guaranteed retirement income for the rest of your life.

Payments usually rise in line with inflation, but this can be capped in some private schemes, which can cause issues when inflation is particularly high.

You may still need other sources of income to keep up with living costs, depending on the level of payments – especially if you only built up a small number of years in a DB scheme.

A fixed proportion of payments may be paid to your spouse, civil partner or dependents when you pass away, depending on the scheme.

It is also possible to get lifelong benefits from a DC plan by purchasing a lifetime annuity with your pension pot, but the rate offered may not be as good as a typical DB scheme payment.

Should I transfer from a defined benefit to a defined contribution scheme?

A DB scheme may provide guaranteed income and higher payouts if you have been a member for a long period, but there are some drawbacks.

There could be rules about when you can access the scheme, and some plans restrict how you take 25pc of the money tax-free, which could result in lower payouts. Payments are also likely to stop when you die, which may not be beneficial if you have a serious health condition.

This is why some people consider DB transfers, where they move to a DC plan to get more flexibility and to combine different pots.

It is a big decision that can mean giving up a lot of valuable benefits and comes with a risk of scams, in which you could end up losing your money when it is transferred into high-risk investments.

It is a regulatory requirement to get financial advice if you want to transfer a DB pension worth more than £30,000.

Joe Dabrowski, deputy director of policy at the Pensions and Lifetime Savings Association, said: “In most cases transfers involve paying some fees and losing some value.

He said: “Additionally, people should consider whether they are comfortable with taking on some of the responsibility of managing their investments, and whether they can achieve sufficient investment returns.”

In most cases, transferring a DB to a DC scheme is not in someone’s best interests, despite how attractive it can look or how high the transfer value might appear, according to Quilter financial planner Chris Flower.

He said: “Giving up a guaranteed income for life is a considerable risk, and the value of a DC pension can fluctuate with the market.

“Individuals considering this should think about their retirement goals, attitude to risk, financial situation and scheme death benefits if there are family members also dependent on their pension income.”

Pros & cons of each scheme

DB schemes have historically been described as “gold-plated pensions” and come with a range of advantages. These include:

• A guaranteed income in retirement, usually increasing with inflation.
• Peace of mind. The responsibility of ensuring it is well funded and invested lies exclusively with your employer.
• Protection. The Pension Protection Fund will pay your pension in retirement if your employer goes bust.

However, there are downsides:

• A set retirement age. You might only start receiving DB payments from a set retirement age. This is often later than in DC schemes, which you can currently access at age 55 – rising to 57 from April 2028.
• A lack of flexibility. You won’t be able to vary how much money you withdraw and there may be limits on how you take tax-free cash.
• Limits on death benefits. They may be paid to a spouse or civil partner when you pass away – similar to a DC scheme – but not always. There could also be limits on how much other dependants, such as children, can receive.

Alternatively, there are pros to a DC scheme:

• Increased contributions. The more you contribute, the more your pot should grow.
• Flexibility. There are additional options at retirement, such as access from age 55. It’s also easier to vary withdrawals because you have the option of drawdown or an annuity, as well as a 25pc tax-free lump sum.

However, the numerous cons are a consideration.

• Running out of money. There’s no guarantee of how much money you’ll have when you retire as it depends on stock market performance and how much you have contributed. This could mean you run out of money, or don’t have enough to retire when you want to.
• Extra retirement planning. You’ll need to think carefully about your decisions, particularly if you’re in drawdown.

Mr Flower added: “When comparing the two, DC schemes offer more control and flexibility but come with greater risk and uncertainty.

“In contrast, DB schemes provide a guaranteed retirement income, offering security and peace of mind, but with less control and flexibility for the individual.”

However, it’s worth remembering that you’re bound by the options offered by your employer – and most private employers will only offer a DC scheme. It’s important to consider whether this will be sufficient for your retirements needs and to make additional plans if you think it’ll fall short.