Too embarrassed to ask: 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.

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