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 have become much more common in the private sector, and help employees save for the future in a different way.

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

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

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

But while DB schemes may be the most valuable pensions, they are mainly suitable for occupations where people do not frequently change jobs, 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 for as long as possible to truly maximise their pension earnings.

This is something increasingly difficult to do as people switch jobs more frequently. This flexibility is a notable advantage of DC schemes. 

Can I transfer my defined contribution scheme?

With the introduction of auto-enrolment, every employer automatically registers new employees into the company’s pension scheme — almost always a DC scheme.

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

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

And, if individuals have a DC plan that offers better investment options and returns than some other pensions, transferring pensions can be a good financial decision.

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?

It is possible to transfer a DB scheme to a DC scheme, however it is unlikely employees will be able to transfer their savings back should they change their mind.

It may also not be the right move financially, as doing so means than people lose access to a guaranteed source of income for their later life.  

On the other hand, transferring your DB scheme into a DC scheme does mean you may be able to retire in a more flexible way.

Some DC schemes let you retire at an earlier age, and let you decide how much money you want to draw down.

With a DB scheme, your pensionable age is usually a little higher and you can’t change how much money you want to draw down at any given point.  

Defined benefit and contribution schemes work in different ways and can change the way you plan for your retirement.

Speak to a financial adviser today and find out what your employer-sponsored pensions mean for your retirement.

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