Defined benefit vs defined contribution: What's the difference?

There are two main types of private pensions that you can use to save for retirement:

• Defined contribution: The most common type of private pension. You get a pot of savings for retirement defined by how much you have contributed, plus any growth from investments.
• Defined benefit: This type of pension is now very rare, and most are being phased out. It’s typically a workplace pension plan that pays out a fixed guaranteed income after retirement, usually based on your salary and how long you’ve been in the job.

As you can see, the two types of pension are pretty different, and it’s important you’re aware of how they work and which pension you’re on. Luckily, we’re here to help make things clear.

In this article, we take you through the two types of private pensions one at a time. And we’ll give some pointers on how to find out which you have yourself.

Defined contribution pensions

A defined contribution pension provides a set pot of money that you can choose how you’ll use in retirement. You might sometimes see them referred to as money purchase schemes.

If you have a defined contribution pension, you’ll pay into a pension fund and your savings will be invested — usually in equities (stocks and shares), bonds and cash. The amount of money that’ll be available to you in retirement is determined by:

• How much you’ve contributed throughout your lifetime. If your pension is organised by your workplace, your employer will contribute too. You’ll also receive at least 20% in tax relief from the government on whatever you’ve saved.

• The performance of the investments. Your contributions will be invested in stocks and shares, government bonds, and cash. The value of your pension will depend in part on how well these investments have performed.

These days, this is by far the most common way to fund your retirement. Aside from being more affordable for employers, it gives you a bit more flexibility in terms of how you manage your savings. For example, you can decide when you access your pension pot, how much you take out, and what your savings are invested in.

You also don’t need to be directly employed to have a defined contribution pension. You can open a self-invested personal pension, or SIPP, where you can save for retirement, no matter your employment status.

Defined benefit pensions

A defined benefit pension provides you with a guaranteed income every year for as long as your retirement lasts.

This type of pension is most commonly a workplace or occupational pension, which is arranged and funded by your employer. The value of your retirement income is based on how much you earned, usually in one of two ways:

• Final benefit or final salary pension. In this case, your retirement income is based on how much you earned when you stopped working.
• Career average pensions. Here, how much you earned over your whole time with an employer, as well as how long you worked with them, determines the value of the pension. Typically, these will be less valuable than final benefit pensions.

Whichever you have, it’s not like a finite pot of money that you can use up, as a defined contribution pension would be. Instead, defined benefit pensions provide you with a regular income that’s usually guaranteed for life. What’s more, it’s typically the responsibility of your employer to make sure there’s enough money to fund your pension. As an employee, you’ll likely contribute too, but how much will depend on your particular pension plan.

As a result, while they’re the more traditional type of pension, defined benefit tends to be more expensive for employers. And that’s exactly why they’re not as common as they once were. These days, it’s unlikely you’ll have one unless you are in the public sector or worked for a large employer earlier in your career.

Hybrid pension schemes

Defined contribution and defined benefit schemes make up the vast majority of pension plans. But it’s worth having on your radar the third, a less common type of pension. That’s the hybrid.

Think of hybrids as a mix of defined benefit and defined contribution. What that mix looks like in practice can change from plan to plan.

For example, with some hybrid schemes, you might be contributing to both a defined benefit and a defined contribution plan at the same time. That might mean that some regular income is guaranteed in retirement, while the rest of your pension is in a pension pot.

Alternatively, you might receive a lump sum when you retire—a bit like a standard defined benefit but not one that’s paid out regularly.

As we said, the form this might take can differ dramatically. You’ll need to talk to your employer to find out how yours works.

How do I know what kind of pension I have?

If you’re an employee, you’ll be automatically enrolled into a workplace pension scheme. But you don’t really have a choice about what kind of pension you have. And, these days, unless you work in the public sector, you’ll most likely be on a defined contribution scheme.

If you’re unsure about what kind of pension you have, your best bet is to get in touch with your employer or pension provider. They’ll be able to tell you what kind of pension you have, how much it’s worth, and any details of the scheme.

That said, the average person has 11 jobs over their lifetime, and it can be easy to lose track of the details of your past pensions. If you’re planning for retirement, it’s smart to dig these out so you can better understand your financial situation.

We can make finding your old pensions easy. We offer a free trace and transfer service to help you track down any past workplace pensions you may have. It’ll give you all the details you need to know about any pensions under your name.

Can I combine my old pensions in one place?

If you have more than one pension, it can be a wise move to combine them:

• It’ll be easier to manage your retirement savings, as you’ll have all your cash in one place.
• You’ll likely pay less in fees.
• You’ll have more control over where your money is invested.

Read our article on the benefits of transferring pensions for more information on why it can be a good idea to combine your old workplace pensions.

With a CIRCA5000 personal pension, you can transfer old workplace pensions that you are no longer paying into one account. However, if you are still working, you cannot transfer the pension you are paying into with your current employer.

However, you can’t always transfer one type of pension to another, and it’s not always a good idea to.

If you’ve got a defined benefit pension it is unlikely that you’ll be able to transfer to a defined contribution pension. In some cases where you are allowed to transfer a defined benefit pension, you’ll need to speak to a special pension adviser to do so.

Recap: Defined benefit vs defined contribution

While defined benefit pensions give you a guaranteed income for life, defined contribution schemes provide you with a pot of money that you have full control over and can decide how to use. If you’re employed, the type of pension you’re on will be decided by your workplace, but you will likely have previous old workplace pensions that you can combine into one pot, to make it easier for you to manage your pensions.

If you don’t know which pension you have, get in touch with us. We can help you track down all your old pensions and unite them.

Disclaimer

When you invest, your capital is at risk. You should carefully consider whether opening a CIRCA5000 pension or transferring your old pensions is right for you. Please note that tax rules and reliefs depend on your personal circumstances and may change. CIRCA5000 does not provide any financial or tax advice, and you are responsible for your own tax reliefs/payments. This article does not represent financial advice. Your investments and the income from them can go down as well as up. It is sensible to seek independent financial advice if your pension is worth £30,000 or more.