If you are saving into a pension, you're likely to have a defined benefit or defined contribution pension.
But do you know what kind of pension you have, how your money is invested, how your contributions accumulate or what you will be entitled to when you retire?
Here’s everything you’ve been too embarrassed to ask about defined benefit (DB) and defined contribution (DC) pensions.
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What is a pension?
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.
In a simple sense, the main goal of a pension is to provide you with money to live off in later life, usually once you have retired from full-time employment.
But at the most basic level, there are two main types of pension - defined benefit and defined contribution. There are various forms of each, complete with varying differences and names, but all pensions 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 on retirement, which is usually based on your length of service with your employer and your earnings over the course of your employment. In this case, you have a guaranteed – or defined – benefit to look forward to.
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 a pension worth two-thirds of your salary to make use of in retirement. This means you have some certainty around what sort of pension you can expect in your later years.
It’s up to your employer to figure out how to fund that pension. For many, the large DB liabilities accumulated over the decades are a drain on balance sheets. They are also complex and require a significant degree of actuarial oversight to ensure that employers’ or schemes’ investment strategies will deliver the sums it has to pay out both today and in the future.
Given this, the investment risk of a DB pension lies with the employer. It can offload it elsewhere to some extent, but the important distinction to note is that the risk does not sit with you, even though you are a beneficiary.
Many defined benefit schemes are closed to new members while some have closed entirely due to the high costs and risks for employers, though they are still prevalent in the public sector as these are ultimately backed by the taxpayer rather than by any individual organisation.
But generally DB schemes are on their way out. The market value of private sector defined benefit pension schemes fell by 12% between June 2022 and September 2022, from £1.45 trillion to £1.28 trillion, according to the Office for National Statistics.
What is a defined contribution (DC) pension?
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.
In many ways, 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 will be responsible for getting your pot to grow, but there’s no guarantee that you’ll receive a certain amount of money - only what is in your pot once you opt to take out your pension.
Commonly, a pension scheme will reduce the level of risk linked to your pot as you get closer 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 many employers and employees contribute more.
Off the back of auto-enrolment, more of us are paying into DC schemes, with total annual contributions across the private sector increasing from £41.5 billion in 2012 to £62.3 billion in 2021, Department for Work and Pensions data shows.
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, although you will be incredibly hard-pressed to find a scheme outside of the public sector.
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 the payouts are guaranteed for the rest of your life.
But that’s not to say DC schemes are not worthwhile. Rather, they will play a hugely important role in many people’s long-term financial planning. The fact is many of us will not have access to a DB scheme, so making the most of DC pots will be crucial to millions of people.
The best way to do this is by making regular contributions and by utilising any tax benefits that may be on offer. To stay up to date with how best to manage your pension, keep an eye on MoneyWeek’s pensions page for news, tips and ideas.
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