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

Defined contribution pension schemes and defined benefit schemes are two different types of company pension schemes, commonly called 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 similarly 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 be invested in stocks, shares, and bonds.

Types of company DC schemes 

• Large insurance companies, on behalf of other companies, normally set up group personal pension chemes (GPP). When an employee leaves the company, the GPP becomes a personal pension.
• The company has set up occupational pension schemes (OPP) for its employees, which are run by appointed trustees.

 

Note: OPP can be either a DC or DB scheme.

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. Also known as final salary schemes.

They are still reasonably common in the public sector, with most 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 scheme's accrual rate, 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 amount of money and working for the same amount of time to see their respective pot sizes.

Let's say your salary is £30,000 a year, and you pay 10% of it into your DC scheme for 10 years. Without compounded growth, it is £30,000.

With a DB scheme with a CETV of 1/60 with the parameters, it is £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 primarily due to the guaranteed income these schemes provide, which is a proportion of the employee's final salary.

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

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 age 55 with a remainder drawdown or used to purchase an annuity.

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

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

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 usually higher, and you can't change how much money you want to draw down at any given point.

Speak to a specialist defined benefit financial advisor today. 

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