What are defined contribution and defined benefit pensions?

What is a defined benefit pension?

A defined benefit pension is a type of workplace scheme that gives you a guaranteed income for life. The amount you get is based on your salary and length of service. 

How much you pay into the scheme and the investment returns do not affect the level of pension you get, although you usually have to make contributions to remain in the scheme.

While these ‘gold-plated’ pensions are increasingly rare in the private sector, they're still common in the public sector, for example for civil servants, teachers and doctors. Some large private sector companies still operate DB schemes, but most are closed to new members.

Types of defined benefit pensions

There are two main types of defined benefit pension:

• Final salary: The payout you get when you retire is a percentage of your salary at the time you leave the company or retire

• Career average:  Your pension is based on your average salary over all the years you work for the company, not just at the time you retire

Investment management and the PPF

Defined benefit pension schemes are usually administered by a board of trustees who are responsible for ensuring that the scheme is well invested and managed. Part of their job is to grow the assets to ensure that there is enough money to meet the scheme's pension obligations. If there is a shortfall, the company is expected to make up the difference. In this way, the strength of the company's promise (its 'covenant') is more important than the actual performance of the underlying investments themselves.

However, if the company goes bust and the scheme is left underfunded, there is a Pension Protection Fund (PPF) that can step in. This guarantees that you will get at least 90% of your promised pension. People who are already at or over retirement age will get 100% of the promised sum.

Calculating your income

Each scheme has different rules that govern how much you receive in retirement, but they all use something called an accrual rate to determine what you get. Under this calculation, each year that you’re a member of the scheme is worth a fraction of your final or career-average salary, such as 1/60 or 1/80.

For instance, say you worked at a company offering a final salary DB scheme for 15 years. When you left the company or retired, you were earning £60,000. Your annual pay-out will be £60,000 x 15 x 1/60. That means you’ll have £15,000 a year to live on.

Most schemes are inflation-linked, which means your income will rise each year, but different companies use different measures of inflation to decide what the increase will be.

You should get a statement each year, predicting what your annual retirement income will be.

Withdrawing money from a DB pension

Your pension scheme will have strict rules about when you can start drawing your pension. Typically, this is 65 or your state pension age, although some schemes will allow access earlier. Check your pensions statement or contact your provider to find out what your options are. If you’re not ready to retire, many schemes will let you delay drawing your pension in return for a higher income later. If you’re in poor health, you might be able to get your pension early.

When you do start accessing the money, you have a guaranteed income for life. This income is taxed at your marginal rate – in exactly the same way you pay income tax on your salary when you’re working. Some DB schemes will let you take a tax-free lump sum, but not all do. Check with your provider to find out what’s available.

When you die, many schemes will pass on a proportion of your pension payment to a spouse, however, there is no pot of savings that you can choose to leave to loved ones.

Learn more about paying tax in retirement.

Can I transfer my defined benefit pension?

You might be able to transfer your DB pension to a defined contribution scheme – for example, if you want to take advantage of pension freedoms legislation or retire early. However, you’re likely to be giving up valuable benefits if you take this approach. Some employers may offer you incentives to switch, such as an enhanced transfer value, but it’s still really important to weigh up what you’re losing.

If the value of your pension benefits (or cash equivalent transfer value) is more than £30,000, you need to take independent financial advice. Even if it’s lower than that, you should consider speaking to an IFA, as once the transfer is complete you cannot change your mind.

If you are in an unfunded public sector DB scheme, you won’t be able to transfer to a DC.

Compare pension transfer plans.

What is a defined contribution pension?

With a defined contribution pension scheme, the amount of money you have available to retire on is determined by five factors:

• How much money you pay in

• How much money your employer pays in

• How much tax relief you get

• Your investment returns

• Fees and charges

You make contributions into a scheme and your money is invested. These investments may be chosen for you, or you might make decisions yourself depending on the type of pension. 

The government gives you tax relief on DC pension contributions. The percentage it pays is determined by your income tax rate. If you’re in a workplace scheme (one provided by your employer), your bosses will contribute too. There is a limit on how much you can pay in, which is equal to the lesser of two amounts: your annual salary or the government-set annual allowance (currently £60,000 a year).

Types of defined contribution pensions

There are several types of defined contribution schemes. The main ones are:

• Workplace pension: A scheme set up by the company you work for, where you pay in money, which is topped up by your employer and tax relief from the government. Most employers now have to provide these under recent auto-enrolment laws.

• Personal pension: A pension you set up yourself, such as a SIPP (Self Invested Personal Pension) or a stakeholder pension. You still get tax relief from the government, but there are no employer contributions.

Investment management and protections

If you’re in a workplace pension scheme, you’re usually invested in something known as the default scheme. This is designed by experts to try and maximise returns and take an appropriate level of risk based on how far you are from retirement. Some schemes will allow you to choose between a range of funds or alternatives to the default.

If you have a personal pension, you can often choose your investments. However, many providers will offer retirement “defaults” where you can just pay in your contributions and let the investment experts decide. Some online platforms will offer you a quiz to determine your risk appetite and pick appropriate investments based on that.

If you have a SIPP, you will be responsible for your investment decisions. However, this is a risky approach unless you have done your research. If you’re thinking of managing your own investments you should consider seeking advice.

Charges

Workplace default investment strategies are subject to a charges cap of 0.75%. This keeps costs low and stops fees from eroding your investment returns. If you’re not in a workplace default, you should make sure you compare charges and fees carefully before selecting a provider.

Withdrawing money from a DC pension

Currently, anyone can access their DC pension scheme funds from age 55. This will rise to 57 from 2028. 

When you reach retirement, you can choose how you take the money. You can mix and match between the different options, but not all schemes offer every alternative, so you may need to transfer to get what you want.

The main options include:

• An annuity: A guaranteed income for life. You can choose different benefits, such as linking your income to inflation or opting for your spouse to get money when you die. You can take 25% of your pension up front as a lump sum. Your annuity payments will be taxed at your marginal rate

• Drawdown: You take a 25% lump sum from your pension and leave the rest of the money invested, allowing it to continue to grow. You then draw an income either as a regular payment or by withdrawing money as and when you need it. Different providers have their own rules about how you can access the cash

• Lump sums (UFPLUS). Your pension stays invested and you take lump sums when you need them. Instead of taking the 25% tax-free up front, a quarter of every sum is tax free whenever you draw it.

Can I transfer my defined contribution scheme?

Yes. Plenty of people transfer their pensions. For instance, it’s quite common to transfer in order to consolidate pots from different jobs or to access a retirement option that isn’t available on their current scheme. 

Some schemes have valuable benefits built in, such as a higher tax-free lump sum or a guaranteed annuity rate option. If you have one of these benefits, you may have to pay for financial advice before transferring. 

Even if you don’t have guaranteed benefits, it may be worth seeing a financial adviser to help you build a retirement plan based on your pension position. There is also plenty of free advice to help you navigate these issues, such as the free, government-provided Pension Wise service for over 50s.