There are only really two types of pension you can have, a defined contribution pension or a defined benefit pension.
Over the last few years there has been a big change in the type of pension scheme offered by employers, moving from defined benefit to defined contribution.
Each one is very different to the other and the one that is right for you will very much depend on what sort of retirement income you want.
Defined contribution pension vs defined benefit: which one is which?
Defined benefit
A defined benefit pension is one that attempts to guarantee you a pension income for the rest of your life at a set ‘retirement’ age.
There is no pot of cash for each individual pension member. Just a promise to pay you a pension income.
The income you receive at the scheme retirement age will be based on a formula that includes:
- What your salary from the company has been.
- How long you have worked for the company.
Basically, the longer you have worked for the company providing the scheme and the higher your salary, the more pension income you will be due at retirement.
A defined benefit pension is also sometimes known as a ‘final salary’ pension because of its link to your salary. But it’s important to be aware that not all defined benefit pensions are linked to your ‘final’ salary before retirement. Some take your average salary over the last 3-10 years.
Defined contribution
A defined contribution pension (also known as a money purchase pension) means you have your own pot that you, your employer and the government (via tax relief) pay into.
Your pot will be invested in the attempt to earn a decent return over the years.
At the point you ‘retire’ there is no guaranteed pension, just the value of your pot on that day. You then decide how you would like to make withdrawals from this pot.
Defined contributions pensions vs defined benefit: the pros and cons
Defined benefit
Pros
- Secure income for the rest of your life – you know what you are getting.
- A reduced secure income for your spouse on death.
- Income is inflation proofed meaning it will keep up with rising prices.
- Stock market crashes have no impact on your pension income.
Cons
- No flexibility on what income you can receive and when.
- Income reduced if you take your pension earlier than the normal scheme retirement date.
- Pension is lost on second death (the death of your spouse after you).
- Risk the company providing the scheme goes bust, leaving the overall pension scheme underfunded and therefore potentially falling into the Pension Protection Fund reducing your overall benefits.
Defined contribution
Pros
- You are in control of your pension pot, you can decide the investment strategy.
- You can consolidate lots of smaller defined contribution pensions into one.
- You can take money out of your pension from age 55 without penalty (subject to individual pension provider rules).
- You have flexibility as to how much income you take and when, meaning you can withdraw more in the early years of retirement and less in the later years of retirement if you wished.
- Whatever is left in the pot at the point you die can be passed onto whoever you choose, usually Inheritance Tax free.
Cons
- Your pension is subject to investment risk meaning poor investment returns could seriously reduce the value of your pot.
- The less you pay in the less the value of your pension will be.
- No guaranteed pension income unless purchasing an annuity which is likely to be much less than a defined benefit income.
- Taking withdrawals from your pension on a flexible basis will mean ongoing monitoring of your pension and a thorough plan to ensure your pension does not run out before you!
So there is no clear winner. The pension that is right for you will depend on your own individual circumstances.
Generally, although not always the case, defined benefit pensions are better for people that have no other pension, are single and have a cautious attitude to investment risk.
If you are someone who has a family, a more adventurous attitude to risk and other secure income then a defined contribution pension might offer you more flexibility. In some cases you may be able to transfer your defined benefit pension to a defined contribution pension.
But it may be the case you don’t have a choice.
If you work in the public sector you will be part of the defined benefit pension with no option to transfer. If you work in the private sector you will probably find unless you have been with the same company for 10 plus years or more, you will not be offered a defined benefit pension.
Here at RTS Financial Planning we specialise in retirement planning. Making sure your pensions are efficient, helping you understand where you are and what you need to do to retire.
Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
