HELP & ADVICE

Defined contribution pensions versus defined benefit: what's the difference?

Defined contribution pension schemes and defined benefit schemes are essentially two different types of company pension schemes, commonly referred to as occupational schemes.

Although both are employer-sponsored schemes, they work in very different ways.

Let's look at the key differences.

What are defined contribution pensions?

Defined contributions, or DC schemes, work in a similar way to personal pensions in the private sector. 

Effectively, what you pay into a DC pension scheme plus growth is what you get out of the pension scheme, with the employer also contributing. 

The funds would then be directed into funds that are invested in stocks, shares, and bonds.

Types of company DC schemes 

• Group Personal Pension Schemes GPP are typically set up by large insurance companies on behalf of companies. When the employee leaves the company, the GPP turns into a personal pension.
• Occupational Schemes (OPP) are set up by the company itself for its employees and run by appointed trustees.

NOTE: OPP can be either DC or DB schemes.

What are defined benefit pensions?

Defined Benefit, or DB, schemes are Occupational Schemes where the employee will contribute to the scheme during their employment; they are not dependent on the level of employee contributions. They are commonly known as Final Salary schemes.

They are still fairly common in the public sector, with the majority of civil service pensions offering final salary schemes. 

However, in the private sector, they are increasingly becoming rare due to the expense of maintaining such a scheme, and employees change jobs far more frequently today than they did a generation ago.

DB schemes usually work by taking a final salary, dividing it by the accrual rate of the scheme, and then multiplying this figure by their length of service.

While employees will make their contributions, DB schemes will continue to pay a regular income regardless of how many contributions an employee has made. 

Which scheme is better?

In answering this, let's look at some calculations over the life span of two employees earning the same and working for the same amount of time to see what their respective pot sizes are.

DC scheme:

Salary: £30,000 for 10 years. 10% per year paid into the DC scheme. £3,000 per year x 10 years = £30,000.

NOTE: No compounded growth was used.

DB scheme:

Salary: £30,000 for 10 years. Cash Equivalent Transfer Value CETV - 1/60 x £30,000 per year x 10 years of service x 20 = £100,000. 

As can be seen from the two calculated pot sizes, DB pension schemes have long been seen as better and more valuable pension schemes to be a part of.

This is largely due to the guaranteed income that these schemes provide, which is designed as a proportion of the employee's final salary.

Can I transfer my DC or DB scheme to a personal pension?

Yes, it is possible to transfer both DC occupational schemes and DB schemes into a single pot. From here, tax-free cash can be accessed from the age of 55 with a remainder drawdown or used to purchase an annuity.

It is one of the best ways to avoid losing track of savings, particularly if people have worked a few jobs.

With DB schemes, transferring out will require specialist financial advice. 

But transferring out the CETV means the pension pot would not be lost due to death and can be passed down to your children through inheritance. 

Also, with a DB scheme, your pension age is normally higher, and you can't change how much money you want to draw down at any given point.

Speak to a financial advisor today. We can connect you with one through Regulated Advice.