The difference between defined benefit and defined contribution pensions

Since pension freedoms introduced in 2015, there has been an increasing number of people transferring out of Defined Benefit pensions – historically referred to as gold plated pensions. So why have these people decided to move out of a pension that promises an income for life to one that doesn’t? This article will look at the difference between defined benefit and defined contribution pensions.

One of the reasons is that the way in which transfer values are calculated has meant that these have been more generous recently however, this should not be the only reason for transferring. It is important to consider how long a pot of money will last compared to a guaranteed income for life.

The difference between defined benefit and defined contribution pensions

Here I will compare defined benefit and defined contribution pensions.

Defined Benefit 

Defined Contribution 

How the benefits are built up

Guaranteed benefits are built up within the scheme based upon number of years’ service, salary and an accrual rate. Benefits are dependent on how much is paid in, the investment returns and plan charges.

When benefits can be taken 

Benefits are taken at the scheme pension age – usually 60 or 65. If benefits are taken before this age, pension benefits may be reduced. Benefits can be taken at any age from 55.

How benefits are taken 

The lump sum and income have to be taken at the same time. You cannot take one and delay taking the other. Although the whole amount could be taken as an income with no lump sum at all. These pensions are flexible in how benefits can be taken. They can be taken as income and/or lump sum(s).

How is income guaranteed

Income is guaranteed for life. If you die and have a spouse, depending on the scheme 50%+ of the pension will be paid to them for the rest of their life Income is not guaranteed if taken directly from a Defined Contribution pension although you could buy an annuity. More about annuities here.

How will income increase

Income will increase annually in line with inflation and the scheme rules Income can increase however, the more you take, the more chance the fund will be eroded.

Who has the risk

The pension scheme takes on the risk that the member lives for a long time and they have to pay them until they die regardless of fund performance. The individual takes on the risk. They have to invest the money. There is no guarantee that the money won’t run out.

Death benefits 

The following death benefits may be paid from the pension:

·         A pre-retirement lump sum paid to a spouse/civil partner

·         A spouses pension (usually 50% or 2/3 of the full pension)

·         A pension to a child under 23 in full time education

The death benefits of a defined contribution pension are:

·         Return of fund or

·         A beneficiary’s pension

This would be tax free if you died before age 75 or taxed at the recipient’s income tax rate post age 75.

If the fund value has been depleted, there may be nothing to pass on to a beneficiary.

In summary

Defined benefit pensions provide guarantees and certainty Defined contribution pensions provide flexibility, risk and uncertainty

 Important considerations

Some important things to consider when looking at transferring are:

  • Are you
    • single or do you have a spouse or partner?
    • in good health?
    • comfortable with risks and uncertainty?
  • Do you :
    • want a guaranteed income?
    • have any other secure income?
    • need your income to vary in retirement?
    • wish to pass death benefits to your family?

This is a very complex area and the decision to transfer shouldn’t be taken lightly. Always seek financial advice.