These two types of pension both have long, confusing names. And the only hint they might be different—that word lurking in the middle— doesn’t tell you much. So, what is it that sets defined benefit pensions and defined contribution pensions apart?
The key difference is:
- with a defined benefit pension, the amount you get is usually based on your salary and how long you've been part of the pension scheme.
- with a defined contribution pension, the amount you get is based on how much you and your employer invest in the pension and how your investments perform.
There are other differences as well
A defined benefit pension gives you a guaranteed income for life. This amount is usually decided in advance by the rules of the pension scheme, though it does increase with inflation (the general rise in prices over time).
Note that defined benefit pensions are sometimes called final salary pensions—pensions whose income is based on your salary at or near retirement. Defined benefit pensions can also be career average pensions, whose income is based on your average salary across your career.
Defined benefit pensions are more common in the public sector, but some private sector employers offer them too. They’re becoming less common as the number of defined contribution schemes increases.
A defined contribution pension may not give you a guaranteed income. The income depends on how much you and your employer invest, how well your investments do over time, and how you decide to take the money out. For example, you can take some or all the money out as a single lump sum or a series of smaller sums, or you can use some or all of it to buy an annuity—a guaranteed income for life, paid out in regular instalments.
Defined contribution pensions often demand more involvement from you than defined benefit schemes, which are usually managed by a Board of Trustees. In a defined contribution scheme, you’ll likely need to make regular decisions about how your money is invested.
Defined Benefits schemes can only provide an income for dependants on your death. Some Defined Contributions schemes provide different types of benefits to a wider range of possible beneficiaries, though the details change from scheme to scheme.
Does the type of pension you have affect the type of tax you’ll pay?
The type of pension you have won’t affect the type of income tax you pay. Most pensions give you the option to take out up to 25% of their total amount income tax free.
Taking out money as a tax-free lump sum can be more complicated with a defined benefit scheme. Providers will usually adjust the amount you get in years ahead to reflect the amount you take out as a tax-free lump sum.
Benefits from Defined Benefits schemes paid to your dependant after your death are taxed, whereas death benefits from Defined Contributions schemes are not normally taxed if you die before your 75th birthday.
Can you transfer from a defined benefit to a defined contribution pension?
It’s not possible to transfer your money from a defined benefit to a defined contribution scheme if,
- you’re already taking money from the pension
- you have a Teachers, Civil Service, Police, Armed Forces or NHS pension. The Fire Brigade scheme will not allow transfers to Defined Contributions schemes, such as Aviva's personal pension schemes, which allow flexible benefits
In other cases, transferring might be possible and could bring certain benefits, such as the opportunity to invest your money differently and potentially boost your income. However, it can also be risky, with the clearest danger being the loss of a guaranteed income that comes from a defined benefit scheme.
Defined contribution pensions are tied to financial markets. If these markets do badly, you could end up with less money than you started with. Although defined benefit pensions aren’t always safe either, most are protected by the Pension Protection Fund (PPF). So, even if your employer goes bankrupt, you’re still likely to get most of the income you expected.
The Financial Conduct Authority (FCA) and the Pensions Regulator (TPR) say that most people in a pension scheme with safeguarded benefits would be better off staying in their existing scheme.
If you’re considering a transfer, it’s best to get personal financial advice. And, if your pension is worth over £30,000, you have to get advice by law. Advisers will charge for this service.
