What’s the difference between defined benefit and defined contribution pensions?
The two types of pension in the UK are called ‘Defined benefit’ and ‘defined contribution’. There are specific differences between the two pension types. In this article, we’ll explain the pros and cons of each one.
The main difference between a defined benefit and a defined contribution is one is characterised by how much you get out each month – defined benefit – and the other is characterised by how much you pay in – defined contribution.
Main Differences Include
Unlike a defined benefit pension, a defined contribution pension does not guarantee your end income.
Money put into the defined contribution pension plan is often invested in funds with the goal of increasing its value. A defined contribution pension pots value might decline as well as grow, and you may get less than you invested.
Currently, you can obtain your defined contribution pension on or after reaching the age of 55, but some defined benefit pensions have a retirement age of between 60 and 65, depending on the scheme. With most schemes, however, you’ll be able to access your pension from 55.
If you have a defined benefit pension, you may be able to begin receiving benefits sooner or later than the set age, but this may have an impact on your future income.
Are few further differences are:
- Defined-benefit pension plan – Employers fund and guarantee a specific retirement benefit amount for each member of the plan.
- Defined contribution plan – These are funded primarily by the individual. In the case of a workplace scheme the employee defers a portion of their gross salary. Employers can match the contributions up to a certain amount if they choose.
- A shift to defined-contribution workplace pension plans has placed the burden of saving and investing for retirement on employees.
It’s important to understand the difference because each type has pros and cons. And we don’t just mean in terms of financial risk and retirement income.
Let’s look at them in more detail.
What Is a defined benefit pension?
Defined benefit pensions – sometimes called a final salary scheme – means there’s one big pot of money, paid by all employees and managed by the employer.
You pay in a fixed and flat percentage of your salary or wages, and the employer pays in a contribution too. When you retire, you get a monthly income.
This is what we call a box pension. Imagine you have a box on your mantlepiece that pumps out pound notes at a pre-agreed level for the rest of your life. You receive a steady retirement income that you can predict and rely on, every month.
If you’re married and die first, your spouse will usually continue to receive a proportion of your pension until they die.
Advantages of the defined benefit scheme
The main advantage of a defined benefit pension is that it’s all done for you. You don’t have to think too much about it. The employer takes on all of the investment risks and thinks about the stock market. You just pay in and – when the time comes – the box pays out.
Disadvantages of a defined benefit scheme
The disadvantage is that this pension dies with you (or your spouse if a spousal benefit is included). If you have dependent children, they can sometimes also benefit.
You can’t usually pass it on to other people you choose.
What is a defined contribution pension?
Defined contribution pensions have lots of different names. You might call yours a SIPP (Self Invested Personal Pension), personal pension, workplace pension or stakeholder pension.
In this sort of pension scheme, you – and if it’s a workplace pension, your employer – pay in a percentage of your wage. But instead of it going into a big communal pension pot, it goes into a pot with your name on it.
After that, it’s up to you. You’re responsible for deciding how and when you access it.
This pension is generally available for access any time after you turn 55. You can withdraw up to 25% as a tax-free cash lump sum (often called a pension commencement lump sum) but you must do something else with the remaining 75%.
There are two options for this: annuity or drawdown.
Pros and cons of an annuity pension (the box)
An annuity is like a defined benefit pension, but you buy into it through an insurer, not your employer. It’s again like a box disPensiong pound notes each month, and as in the case of a defined benefit pension, it dies with you or your spouse, you can’t usually pass it on.
The benefits of an annuity pension
Guaranteed – payments continue throughout your life (or agreed term) and are protected by the Financial Services Compensation Scheme (FSCS).
Simple – no need to worry about investments or market volatility.
Customisable – you can tailor it to what you want at the outset.
The disadvantages of an annuity pension
Inflexibility – once you’ve set what you’re getting you can’t change this and take more or less at a later date.
It dies with you (or your spouse if a spousal benefit is included) – generally speaking, when you die the payments stop, so no money can be passed to beneficiaries such as your children.
The benefits of drawdown
Pension drawdown is different. Drawdown is like having a barrel with a tap at the bottom. In the barrel is your money – invested and hopefully growing in value. When you need money, you can turn on the tap and take out what you need.
The main benefit of drawdown is that the money in your pension pot is yours forever. When you die, the remaining money can be passed on to your spouse, children, grandchildren or even your favourite charity.
However, there are risks. The most obvious one is that the investment risk is on your shoulders.
Unlike a defined benefit pension or an annuity – where the employer or insurer have to worry about the ups and downs of investments – with drawdown, that responsibility is yours. You decide where to invest your money. Luckily, this can be made easier by getting advice from an independent financial adviser, who can help you navigate your options.
So, what’s the other risk? Well, that’s about psychology…
For further reading see the pros and cons of pension drawdown.
The disadvantage of drawdown
Hopefully, now you understand the difference between boxes (defined benefit pensions or annuities) and barrels (drawdown from a defined contribution pension). And you know some of the pros and cons of each.
But there’s one unexpected downside of barrels/drawdown that is important to understand.
You see, we humans are programmed with a scarcity mindset. That means we try to protect ourselves by keeping hold of the things we need. We’re like squirrels at heart, hoarding nuts for the winter. Just think about toilet paper during the pandemic…
So, when we have a barrel of money, it can be very hard to spend it.
A box disPensiong pound notes each month is seen as ‘income’. We are happy to spend our income because it isn’t perceived as scarce. It keeps coming every month – and we’ve earned it – so we spend it. Holidays, hobbies, treats for the grandchildren.
But a barrel of money that has to last for the rest of our lives? That’s savings. That’s nuts for the winter. That’s the children’s inheritance. We don’t like to touch it.
This mental block can become a serious barrier to enjoying your retirement. Often, people hoard their money for so long that they don’t actually get to enjoy the active stage of their retirement when they should be making the most of their newfound freedom.
Should I transfer from a defined benefit to a defined contribution scheme?
A common reason for looking to take advice about your DB scheme is the possibility of greater flexibility. If you’ve got a defined benefit pension, but like the sound of this, in most cases, you can opt to transfer it to a defined contribution (DC) scheme, which gives you the option to move your pension into Drawdown.
Like everything in life, too much freedom isn’t always a good thing. If you use that flexibility to overspend, your pot could run out quicker than you anticipate. Plus, there are investment risks and also tax implications should you take large amounts from a drawdown pension there are also investment charges and advice charges that aren’t payable in a DB scheme.
Don’t get stuck with money you’re scared to spend
At Joslin Rhodes Pension & Retirement Planning, we don’t just understand money, we understand people. Our unique PlanHappy lifestyle retirement planning process doesn’t just look at facts and figures, it looks at retirement as a whole.
We understand the challenges, emotions and barriers people experience around pension planning. And yes, that includes not wanting to spend your hard-earned retirement income. We’ll help you understand your pension pots – and silence your inner squirrel – so you can invest wisely and spend confidently.
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