Could you help me understand the difference between a defined benefit and a defined contribution pension scheme? I hear a lot about both DB and DC schemes, but I’m not entirely what they mean. Are they the same thing as final salary and money benefit plans?
- Jonathan Cooper
- Senior Paraplanner
Defined Contribution Pensions vs Defined Benefit Pensions
Alongside the state pension — which everyone who’s made sufficient National Insurance contributions receives from the government at their state retirement age — there are two main types of personal pension.
A defined contribution (DC) pension scheme is based on how much has been contributed to your pension pot and the growth of that money over time. It may be set up by you or an employer.
A defined benefit (DB) plan is always set up by an employer and offers you a set benefit each year after you retire. This benefit doesn’t depend on investment performance and is usually based on your final salary or a career average, as well as your length of service with your employer.
Defined contribution pensions can be either workplace pensions arranged by your employer, where both you and your employer contribute to the plan, or private pensions, which you arrange yourself and pay into separately from any employer. This might be the option you choose if you’re self-employed, for instance.
Value of Defined Contribution Pensions
The value of a DC plan is based on money contributed into the pension scheme. The contributions are invested by the pension provider, and the performance of the fund — and therefore, to some extent, the size of the pension pot you’ll get — can go down as well as up depending on how the underlying investments perform.
The size of your pension pot will also depend on number of other factors, including:
- How much your employer and / or you contribute
- How long you save for
- Any charges deducted by your pension provider.
Retirement Income from a Money Purchase Pension Scheme
From the age of 55, you can take this pot of money and use it to provide you with a retirement income, perhaps by purchasing an annuity, entering into income drawdown or taking some or all of the pot and investing it in another way to provide a return to live on. You can use your pension pot to purchase a mix of these incomes if you wish.
Retirement income from a money purchase pension plan is not guaranteed and will depend on how much you take out as a cash lump sum (you can take up to 25% of the pot tax-free) and how you decide to provide yourself with a retirement income.
If you opt for an annuity, your income will depend on your health, annuity rates at the time of your retirement and whether you want to include a spouse (known as a joint annuity).
If you choose income drawdown, your retirement income will depend on the investment performance of the cash you put in your drawdown fund. Similarly, if you opt to invest your pension pot another way, the income you receive and how long it lasts will all depend on how the investment performs.
HMRC taxes pension income like any other income, including lump sums taken out of your pot, so you’ll need to consider the tax implications of your choices.
You’ll also have to think very carefully with regards to how long you think you’ll live and how much income you’ll need for the rest of your life, because if you choose not to purchase an annuity, the pot of money from a defined contribution pension scheme is finite and can run out if you overspend or your investments perform poorly.
As you approach retirement, it’s well worth considering talking to a financial adviser and / or a pensions adviser. They’re well-placed to discuss options for buying a retirement income that works for you.
What is a Defined Benefit Pension Scheme?
Defined benefit pension plans are sometimes known as final salary pension schemes or career average pensions. They’re always workplace pensions arranged by your employer; you can’t contribute to one of these on your own.
A DB pension offers you a guaranteed income for life after retirement, usually indexed to keep up with inflation.
How Are Defined Benefit Pensions Calculated?
The income you receive from a final salary / career average pension is based on three factors:
- How many years you’ve been with that employer and have been contributing to the DB scheme
- Your pensionable earnings (for final salary schemes, this is your salary at retirement; for career average schemes, this is your average salary across your career)
- Your accrual rate (what proportion of your earnings you’ll get for each year spent in the scheme, usually represented as a fraction, e.g. 1/80th).
Your pension income from a DB scheme is therefore most commonly calculated as follows:
Defined Benefit Scheme Calculation
Number of years in scheme
£50,000 final salary
Scheme accrual rate
10 years * £50,000 * 1/80th
Are Defined Benefit Pensions Disappearing?
Final salary schemes or career average pension plans used to be far more common, but today they’re only really provided by the largest employers or the public sector. This is because of expense of maintaining DB pension schemes.
Although the employee usually contributes to the plan along with the employer, the emphasis is on the employer to ensure there’s enough money in the scheme to secure you an income when you retire.
The largest public sector schemes — such the armed forces, civil service, NHS, firefighters, police and teachers — are all known as ‘unfunded’ DB schemes. This means that there’s no central pot of money to pay the pensions of retirees; instead, the government pays directly.
Other public sector DB pension schemes, such as the Local Government Pension Scheme (LGPS), are funded defined benefit plans. This means there is a central pot of money responsible for paying people pensions. Final salary / career average schemes offered in the private sector will also almost always be funded schemes.
However, for funded plans investment performance has not always kept pace with the forces of inflation and increasing longevity.
With people are drawing on DB pensions for longer than was ever assumed they would when the schemes were set up and a series of economic shocks since the 1980s, the biggest of which was the financial crisis of 2008/09, the finances of some funded defined benefit schemes has become stretched to the point where it is unaffordable. The result for many employers has been closure of legacy DB schemes to new members and setting all new recruits up with a DC scheme instead.
The UK government was so concerned with the insolvency potential of employers’ DB schemes that it set up the Pension Protection Fund in 2005 to be the pension provider of last resort if a defined benefit pension plan became insolvent.
Can I Transfer My Pension from One to Another?
It may well be possible to transfer your DB pension into a DC pension, depending on your scheme.
Since April 2015, it’s not been possible for members of unfunded public sector pension schemes to transfer out. This is to prevent the government from having to meet the costs of pension transfers at a time of tightening fiscal policy. However, many funded pension plans are still permitting you to transfer your defined benefit pension to a defined contribution scheme.
There are benefits to transferring your DB pension into a DC scheme, including particularly high transfer values for defined benefit pensions in today’s market and an ability to invest the money to take advantage of further gains in the markets.
If you control your pension pot, then you don’t need to worry about your employer’s DB pension scheme going insolvent and being unable to pay you what was promised.
However, moving your pension from a final salary scheme to a money purchase plan also comes with risks. Transfers are final: once you give up the right to a set income for the rest of your life, you can’t change your mind. Although you can take advantage of rises in the markets, on the flip side you’re also therefore vulnerable to any future crashes.
Leaving your defined benefit pension scheme is unlikely to be right for most people, who’ll typically be better off staying in. To calculate how much your final salary pension could be worth if you transferred out of the plan, consider using Drewberry’s Final Salary Pension Transfer Calculator.
To transfer a DB pension to a DC pension, you’ll need to seek financial advice if the transfer from your defined benefit pension is worth over £30,000.