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Defined Benefit vs Defined Contribution Pension

Defined Benefit vs Defined Contribution Pensions

If you are saving for retirement in the UK, you will usually have either a defined benefit pension (DB pension), a defined contribution pension (DC pension), or perhaps even both. But what are they? What is the difference between defined benefit and defined contribution pensions? And which one is better for you? Let’s take a look at DB pensions vs DC pensions, and what they each offer.

What is a defined benefit pension? (DB Pension)

A defined benefit pension or DB pension is kind of how it sounds. The ‘benefits’ you receive in retirement are ‘defined’ or fixed. DB pensions give you a guaranteed income after you stop work. As these are workplace-based pensions, how much money you get will be ‘defined’ based on your salary and length of service with your employer at the point you retire.

You usually need to make set contributions towards your pension during your career in order to be part of the company pension scheme. However, with a DB pension, the amount you pay into the scheme and the returns that the company’s pension fund achieves will not affect the level of pension you get.

So, you get a guaranteed income for the rest of your life that isn’t affected by investment performance. If that sounds too good to be true, you’re almost right. Defined benefit pensions are increasingly rare outside of the public sector. Some big companies still use them for long term employees, but they will be closed to new members.

Different types of defined benefit pensions

Defined benefit pensions come in two main forms:

Final salary: A final salary pension pays you a percentage of your whatever your salary is when you leave the company or retire from the company.

Career average: Like it sounds, a career average pension is based on what your average salary at the company was, over all the years you worked there.

For both types of DB pension, most schemes are inflation-linked. This means your income will rise each year in line with inflation. Different companies use different measures for calculating inflation. However, you should get a statement each year, predicting what your annual retirement income will be for next year including inflation.

When can I access my DB pension?

Rules vary by pension scheme, but usually you can start taking your defined benefit pension from state retirement age, currently 65. For more on how you can take your DB pension, check out our detailed blog on how does a defined benefit pension work?

What is a defined contribution pension?

With a defined contribution pension, as the name suggests, the money you will have to live off in retirement is based largely on your ‘contributions’ into the pension scheme, as well as some other factors.

What factors influence the value of a DC pension?

The five factors that influence how much your DC pension will be worth, include:

Your contributions: How much money you pay into your pension

Employer contributions: How much money your employer pays into your pension

Tax relief: How much tax relief you get on your contributions based on your tax bracket

Investment returns: How the investments made with your pension fund perform

Fees and charges: The costs for the management of the scheme you are part of

Types of defined contribution pensions

There are others, but the main two types of DC pension scheme are:

A workplace pension: This is setup by your employer. You make contributions and your employer will also make contributions. With some exceptions for high tax bracket earners, your contributions will automatically have tax relief applied via the PAYE system.

A personal pension: A pension you set up yourself. In this case, you will be the only one making contributions. You will still get tax relief from the government, but as contributions are not made via PAYE, tax relief will automatically be applied for by whoever is managing your scheme.

When can I access my DC pension?

Currently, anyone can access their DC pension scheme funds from age 55. This will rise to 57 from 2028. There are also multiple options on how you choose to take your DC pension. For a detailed breakdown check out our blog on how does a defined contribution pension work?

Is a Defined Benefit or Defined Contribution Pension Better?

Wondering if a defined benefit pension or defined contribution pension is better for you? Well, now we’ve covered the main points behind DB and DC pensions, let’s do a quick comparison of defined benefit vs defined contribution pensions.

Defined Benefit vs Defined Contribution Pension – Income Levels

DB Pensions: The benefits are defined or fixed. Defined benefit pensions give you a guaranteed income throughout your retirement.

DC Pensions: No guaranteed level of income I retirement. Multiple factors will influence the money you have entering retirement and in each year that follows.

Defined Benefit vs Defined Contribution Pensions – Contributions & Investments

DB: The amount you pay into the scheme and the investment returns of the pension fund do not affect the level of pension you get. If investments go up you will not benefit, if they go down you will not suffer.

DC: Your pension pot at retirement and throughout is largely based on your ‘contributions’ into the pension scheme, as well as any employer contributions, investment performance and more. If investments go up you’ll feel the benefit, if they dip a bit you might take a little less until they rebound.

Defined Benefit vs Defined Contribution Pension – Scheme Types

DB Pensions

Final salary: Pays a percentage of your whatever your final salary at the company

Career average: Pays a percentage of your career’s average salary at the company

DC Pensions

A workplace pension: Setup by your employer. You and employer make contributions. You most likely don’t get to choose how the pot is invested.

A personal pension: A pension you set up yourself or through an advisor like Lomond Wealth. Investments can be high risk doing it yourself. No employer contributions.

Defined Benefit vs Defined Contribution Pension – Inflation Protection

DB Pensions: Most schemes are inflation-linked, but check how your company calculates this.

DC Pensions: Mostly not linked to inflations, relies on investment performance to stay ahead of inflation. You can purchase an ‘annuity’ to keep up with inflation.

Defined Benefit vs Defined Contribution Pension – Drawdown Options

DB Pensions: Access your pension from 65 or your state pension age (some earlier access schemes)

DC Pensions: Access your pension from the earliest retirement age of 55, allowing the option for early retirement.

Summary: Is a defined benefit or defined contribution pension better?

All types of pensions carry benefits, limitations, and risks. Whatever pension scheme you are in, or thinking of joining, we highly recommend taking professional financial advice from a Chartered Firm like Lomond Wealth at least twice. Once during you career, and once again in the lead up to your retirement.

Lomond Wealth is ranked in the Financial Times’ Top 100 Advisors in the UK. So, if you have any questions, contact our team today to get straightforward answers you can trust.

 

Related Topics

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How do defined contribution pensions work?

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