Defined benefit vs defined contribution pensions: what’s the difference?

Defined benefit and defined contribution pensions are two different types of employer-sponsored pension plans.

Although they share some similarities, they work in quite different ways and can affect your retirement planning.

Let’s take a look at how they work and their key differences.

What are defined benefit pensions?

Defined benefit (DB) pensions are also known as final salary pensions or career average pensions.

Although DB schemes can still be found in the public sector, they are extremely rare in the private sector as they are expensive to run. 

A DB pension guarantees employees an income for life based on how long they worked for a particular employer and their final salary, or career average, while working there.

Based on these factors, employees are given a regular source of income throughout their retirement, and this amount is usually much higher than other defined contribution (DC) schemes.  

DB schemes usually work by taking a final salary, dividing it by the accrual rate of the scheme, or the rate at which an employee’s pension lump sum has increased, and then multiplying this figure by their length of service.

While employees will make their own contributions, DB schemes will continue to pay a regular income regardless of how many contributions an employee has made.  

What are defined contribution pensions?

DC schemes are the most common type of pension in the private sector and help employees save for the future differently.

Over time, both employees and employers make contributions to a pension pot. This pot is then typically invested into things like stocks, shares and bonds, which aim to help the funds grow over time.

Because DC schemes are invested, pension savers don’t know what their pot will be worth in retirement.

This means they take on investment risk themselves, and their eventual pot size depends partly on how the stock market performs and how much they contribute.

There are many different types of DC schemes, but some examples include: 

• Group personal pensions
• Master trust pensions
• Self-invested personal pensions (SIPP)
• Stakeholder pensions

DC pensions work differently than DB pensions and are typically less generous.

Which scheme is better?

DB pension schemes have long been seen as the most desirable and valuable pension scheme to be a part of.

This is largely due to the guaranteed income that these schemes provide.

However, for this same reason, most of these pensions have been phased out of the private sector due to their significant expenses.  

In contrast, DC pensions do not offer a set pension income, and the pension saver takes on investment risk, as their returns are not guaranteed.

But while DB schemes may be the most valuable pensions, they are mainly offered in jobs where people do not frequently change employers, such as those in the public sector.

As the eventual income that employees receive as part of their pension comes down to their final salary or career average, individuals need to remain in a role or sector for as long as possible to maximise their pension earnings. 

Can I transfer my defined contribution scheme?

Following the introduction of auto-enrolment in 2012, every employer automatically registers new employees into the company’s pension scheme, which is almost always a DC scheme if you work in the private sector.

When an employee leaves a role, the pension savings accrued will remain in this company scheme unless the employee decides to consolidate their different workplace pensions, transfer them into a different pot or retire.  

Transferring different pension savings into a single pot is one of the best ways to avoid losing track of savings, particularly if people have worked a few jobs.

Combining your pension pots makes it easier to keep an eye on your pension and work out if you’re on track for a decent retirement income. It can also save on admin and make it easier to monitor your investment returns.

If you are considering transferring, it’s important to check the small print of your current scheme to ensure you won’t lose out on any valuable benefits.

But, with most DB schemes now closed, it is unlikely employees can transfer funds from a DC pot into a DB one. 

Can I transfer my defined benefits pension?

Some pensions, like the teachers’ and NHS pensions, don’t allow transfers to a DC scheme, but it may be possible to transfer to some other DB schemes.

You need to be extremely careful, as transferring out of a DB pension is usually an irreversible decision, and you will lose the right to a guaranteed income.

Transferring to a DC pension also means you will increase your investing risk as the value of your investments and pension pot could go up or down.

On the other hand, DC schemes may allow more flexibility about how much and when you withdraw money from your pension. Most DC schemes allow you to withdraw your pension from age 55, rising to 57 in 2028.

You need to check your scheme carefully before considering transferring, as schemes have different rules on the tax-free lump sum and your retirement age. You may lose valuable benefits by transferring.

It’s vital to take advice before you transfer, and you will legally need advice from a financial adviser if your DB pension is worth more than £30,000.

They will need to provide evidence to the scheme you have chosen that the transfer is in your best interests.

Need help with your pensions?

It can be daunting thinking about what type of pension is best for you and how to maximise your pot for retirement.

Unbiased can quickly match you with a qualified financial adviser who can offer vital guidance, including what your employer-sponsored pensions mean for your retirement.