Workplace pension schemes: how do defined benefit schemes differ from defined contribution ones?

While a decent wage and good hours are what we tend to look for in a job, the workplace pension scheme on offer should also be a key focus.

With the cost of a decent retirement on the up, and uncertainty over the future of the state pension, it's getting more and more important to think about the sort of pension deal you're getting from your employer.

Under auto-enrolment laws, companies have to sign up most of their staff to a workplace pension scheme. The majority of these arrangements are what are known as defined contribution (DC) pensions. They involve the employee putting in 5% of their wage, and the company they work for topping this up by 3%.

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Some firms go even further with what they offer to put in. Indeed, all workplaces may have to stump up more in future, as Labour is being urged to increase legal minimums. The government is currently reviewing the pensions market.

But some firms still offer defined benefit (DB) schemes. So, what is the difference between these two types of workplace pension scheme - and what will you be entitled to when you retire? Here’s everything you need to know.

What is a workplace pension?

A workplace pension is a tax-efficient savings vehicle, or ‘tax wrapper’, that allows you and your employer to invest for your long-term future. In a simple sense, the main goal of these pensions is to provide you with money to live off in later life, usually once you have retired from full-time employment.

All pensions associated with a job will fall under either the DB or DC umbrella. And understanding the difference can help you ensure that you are better prepared for your retirement.

What is a defined benefit (DB) pension?

If you have a defined benefit pension, then you will be paid a specific income when you retire. In other words, you will have a guaranteed – or defined – benefit to look forward to. The amount you get will normally be based on how long you've worked for your employer, as well as what salary you've been on.

So, for example, let’s say that for each year of service, you get 1/30th of your annual salary. If you work for that employer for 20 years, then you will have an annual pension that will be two-thirds of your salary. This sort of pensions provides certainty for your retirement, given you'll know exactly what you'll be getting each year.

Sadly, this type of pension is a dying breed. Not only do we all tend to move jobs more frequently than in the past, but the drain DB schemes have on company finances are making them increasingly unpopular among businesses. It’s entirely up to your employer to figure out how to fund the overall pension pot, and these liabilities can accumulate significantly over decades.

This kind of pension is also complex and requires a significant degree of actuarial oversight. This is needed to ensure that the investment strategies used by employers or the schemes themselves will deliver the necessary sums to meet their liabilities - both present and future.

All of the risk lies with the employer. It can offload it elsewhere to some extent, but the important distinction to note is that you do not shoulder any risk, even though you are a beneficiary.

Most of the defined benefit schemes still in operation are closed to new members, while some have closed entirely due to the costs involved. Indeed, the market value of private sector DB pension schemes fell 12% from £1.45 trillion to £1.28 trillion between June 2022 and September 2022, according to the Office for National Statistics.

What is a defined contribution (DC) pension?

Most employees working today will have a defined contribution scheme at their workplace. According to Department for Work and Pensions data, total annual contributions across the private sector have increased from £41.5 billion in 2012 to £62.3 billion in 2021.

With this sort of pension, the size of your future pot will depend on how much money you and your employer pay into it over the course of your career, as well as the returns the money makes.

In other words, there are no guarantees about how big your pot will be by the time you retire. This can be problematic given most of us aren't putting enough away to live comfortably in retirement, often through no fault of our own.

DC pensions work like a regular investment pot, albeit with some different regulatory protections and practices. One of the main similarities between a regular investment pot and a DC scheme is that the risk sits with you. Your pension scheme provider will be responsible for getting your pot to grow, and there’s no guarantee that you’ll receive a certain amount of money from that pot.

The level of risk tends to reduce the closer your get to retirement. Some providers give you a say in how much risk you’re comfortable with and also offer alternative strategies, such as ethical and Sharia-compliant funds.

The onset of auto-enrolment introduced many workers to DC pots. Under the current terms of the auto-enrolment scheme, workers are required to contribute at least 5% of their salary, which is then topped up by 3% from the employer.

This is only the minimum total contribution, and some employers and employees contribute more. If you're on a high salary, it can be particularly tax efficient to put more of that salary into your pension, especially given that the annual allowance recently became more favourable and that there is no longer a lifetime tax-free limit.

Which kind of pension is best?

On paper, a defined benefit scheme, with its promise of a guaranteed, inflation-linked income, is almost always the better pension scheme. But you will be incredibly hard-pressed to find a scheme.

This is especially true when you consider the cost of buying an annuity, a sort of insurance product which is often purchased by retirees as it provides a steady income until you die. In general, it would take an above-average DC pot, and subsequently a large annuity purchase, to match the income of a DB scheme.

Moreover, a DB scheme offers security as payouts are guaranteed for the rest of your life. But that’s not to say DC schemes are a waste of time. They will play a increasingly important role in people’s long-term financial planning over the coming decades. So, you should aim to make the most of your DC pot.

The best way to do this is by not opting out of your workplace pension at the auto-enrolment stage, making regular contributions, upping those contributions (if you can afford to do so), and utilising any tax benefits that may be on offer.