What’s the difference between a defined benefit pension and a defined contribution pension?

Broadly speaking, there are two types of pension schemes – defined contributions and defined benefits. But what's the difference between them?

A pension is simply a tax-efficient savings vehicle, or “tax wrapper”, that allows you or your employer to invest for your long-term future.  For most of us, the main goal of a pension is to provide us with money to live off in later life, usually once we’ve retired from full-time employment. The rules governing pensions can seem confusing, particularly as the government fiddles with them at almost every other budget. But at the most basic level, there are two main types of pension. 

There are defined contribution pensions (sometimes called “money purchase schemes”). And there are defined benefit pensions, also known as “final salary schemes”. 

If you have a defined contribution pension, then the size of your future pension pot will depend on how much money you put into the pension, and the investment returns you make on that money. In other words, there are no guarantees as to how big the pot will be or how much income you will be able to generate when you retire.  

If you have a defined benefit pension, then you will be paid a specific income on retirement, which is usually based on your length of service and your earnings over the course of your employment. In this case, you have a guaranteed – or defined – benefit to look forward to. Your employer is the one who has to worry about how to fund it. 

In other words, if you have a defined benefit pension, your employer takes all the investment risk. If you have a defined contribution pension, you take all the investment risk.  

Most people working in the private sector these days are paying into defined contribution schemes. Employers are unable or unwilling to shoulder the cost of expensive defined benefit schemes. Most people working in the public sector still have defined benefit schemes, as these are ultimately backed by the taxpayer rather than by any individual organisation.  

A defined benefit scheme, with its promise of a guaranteed, inflation-linked income, is almost always the better pension scheme. The amount of future annual income that can be bought with a given lump sum of money is much smaller when interest rates are low than when rates are high. At current low interest rates, a defined contribution pension holder would have to have a very large pension pot indeed to match the income promised by an equivalent defined benefit scheme. 

To find out more about pension planning, subscribe to MoneyWeek magazine.

Recommended

Early repayment charges: should you abandon your fixed-rate mortgage for a new deal now?
Mortgages

Early repayment charges: should you abandon your fixed-rate mortgage for a new deal now?

Increasing numbers of homeowners are paying an early repayment charge to leave their fixed-rate mortgage deal early, and lock in a new deal now. Shoul…
30 Sep 2022
Energy meter reading day: why you need submit your gas and electricity readings now
Personal finance

Energy meter reading day: why you need submit your gas and electricity readings now

Energy meter reading day - you need to submit your gas and electricity readings as soon as possible ahead of the October energy price increase
30 Sep 2022
Should you take a 25% tax-free pension lump sum in instalments?
Pensions

Should you take a 25% tax-free pension lump sum in instalments?

Taking out a 25% tax-free lump sum sounds appealing but it might not be the best way to manage your pension
30 Sep 2022
Should you fix your mortgage? Here are the best rates available now
Mortgages

Should you fix your mortgage? Here are the best rates available now

Rising interest rates look set to spring a nasty surprise on millions of homeowners next year. You need to take steps today to protect yourself from a…
30 Sep 2022

Most Popular

Why everyone is over-reacting to the mini-Budget
Budget

Why everyone is over-reacting to the mini-Budget

Most analyses of the chancellor’s mini-Budget speech have failed to grasp its purpose and significance, says Max King
29 Sep 2022
How the end of cheap money could spark a house price crash
House prices

How the end of cheap money could spark a house price crash

Rock bottom interest rates drove property prices to unaffordable levels. But with rates set to climb and cheap money off the table, we could see house…
28 Sep 2022
Why UK firms should start buying French companies
UK stockmarkets

Why UK firms should start buying French companies

The French are on a buying spree, snapping up British companies. We should turn the tables, says Matthew Lynn, and start buying French companies. Here…
28 Sep 2022