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

Defined Contribution vs Defined Benefit Pensions: A Comparison

Written by Retirement Line

Many of us approaching retirement do so having built up several pension schemes throughout our careers. If you are a member of defined contribution and defined benefit schemes, it’s important to understand how they differ.

Both pension types have distinct features, advantages and challenges that can impact your retirement income options. In this article, we will explore the main differences between defined contribution (DC) and defined benefit (DB) pensions, and point you to our comprehensive guides on each type.

What is a defined contribution pension?

Defined contribution (DC) schemes are also known as ‘money purchase’ pensions. They can either be a workplace pension scheme, or a personal pension that you set up yourself with a pension provider.

With a workplace DC scheme, you typically make regular contributions into it. Your employer will usually match these contributions or top them up. 

If you set up a private pension such as a self-invested personal pension (SIPP), then you will decide how much to pay into your pension and how often you contribute.

The money will be invested until you retire, which means the value of your fund can go down as well as up. The total amount you end up with depends on how much money is paid in and how well the investments perform. If investments perform badly, you could get back less than what you paid in.

You will typically need to proactively decide how to turn your pension savings within a DC pension into income. From the age of 55 (57 from 2028) you can turn your savings into income in a number of ways. These include purchasing an annuity, arranging a drawdown scheme, taking lump sums, or doing a combination of these. Make sure you understand your options well before your planned retirement date.

You can read more in our guide to defined contribution pension schemes. This includes information about tax relief on the money you pay into your scheme, and your options for taking an income when you retire. 

What is a defined benefit pension?

A defined benefit (DB) scheme offers UK employees a predefined income for retirement, typically based on your years of service and final or average salary. 

Although DB schemes can still be found in the public sector, they are less common today – and quite rare in the private sector – as they are expensive and complex for employers to run.

DB schemes tend not to require you as an employee to contribute a percentage of your salary to your fund. Instead, your employer is responsible for paying into it. Some schemes DO ask you to contribute, although you get tax relief on any payments you make.

Your employer is responsible for making the investment decisions, so the onus is on them to bear the full investment risk.

You can read more in our guide to defined benefit pension schemes. This includes information about when you might receive an income from the scheme. 

Summary: defined benefit vs defined contribution pensions 

Defined contribution pensions offer employees flexibility and control over their investments but come with the risks of market fluctuations and uncertain income. The responsibility lies with you to pay enough into your fund to provide a sufficient retirement income one day. You will also need to decide how to turn your savings into income. 

On the other hand, defined benefit pensions provide a guaranteed income for life, sometimes without any need for you to pay into your fund. Your retirement income won’t be affected by investment performance; even if they do perform poorly, your income must still be paid in full. 

FAQ's

Is a SIPP a defined contribution pension scheme?

A Self-Invested Personal Pension (SIPP), is a type of defined contribution personal pension scheme. It works in a similar way to a standard personal pension but it gains you access to a wide range of investments. You therefore have more choice as to how your money can be invested and grow than a typical personal pension. 

Do defined benefit pensions increase with inflation?

Yes, a defined benefit pension income not only guarantees an income for life, but one that rises each year to protect against inflation. Some DB schemes will increase the pension payouts annually in line with inflation. However, most have a cap on the rate at which income payments increase, typically around 5% per year.

Is a defined benefit pension the same as final salary?

A final salary scheme is a type of defined benefit pension. Instead of you having to build up a pension pot over your career, a final salary scheme provides you with a guaranteed annual income for life which is based on a percentage of your salary when you leave the scheme. You typically won’t have to make any contributions to your pension during your employment, though some schemes may require you to.

Does MPAA apply to defined benefit schemes? 

The Money Purchase Annual Allowance (MPAA) imposes a limit on the amount of money that you can pay into your pension and still receive tax relief. It is only triggered when you access your defined contribution pension pot for the first time. It does not apply to defined benefit pension schemes.

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