The difference between defined contribution and defined benefit pension scheme

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Pensions seem like a complicated topic for most, but Raindrop makes pensions easy - easy to find and easy to understand. This is because at the end of your career, you could have a mix of pensions - from personal to several workplace pensions - and keeping up with each pot and each type of pension can be difficult. 

Simply, a defined benefit pension scheme is a scheme where you know what you’ll get monthly as a pension when retired, while a defined contribution pension is a scheme where regular contributions are made into it and the money is invested. At the end you get what you have contributed and any growth or loss in investment value over time.

The three main types of pensions in the UK are

  • State Pension - pension provided by the Government depending on your National Insurance contributions while employed
  • personal pension - a private type of pension, for you with tax top-ups from the Government,
  • and workplace pension - arranged by your employer and contributions are made by you and your employer. 

In each pension, you save differently depending on how your pension is saved in your pot. A workplace and personal pension usually follow the defined contribution scheme’s guidelines because the way you save into those pensions is by contributing. 

In a workplace pension, instead of contributing, you can also pay into it following defined benefit scheme’s guidelines; your pension payments are defined by your final salary or an average of your salary with that employer. 

Keep on reading to find out the difference between the two schemes. 

Defined benefit pension scheme

What is a defined benefit pension scheme?

It’s a way of paying into your workplace pension, it’s a scheme, and the retirement money you are entitled to is calculated based on either your final salary or the average of your final salary with your employer. 

This type of pension scheme is arranged by your employer and the amount you get on your retirement depends on:

  • the years you've worked for this company - the longer you work, the more pension income you'll get
  • the salary you were paid by the end of your time with that employer - in other words your 'final salary' pension
  • an average of your salary over your whole career - in other words your 'career average' pension.
  • the accrual rate, which is multiplied by your earnings to calculate your final salary pension. Accrual rate is different depending on the pension scheme as it is a ‘pension interest rate that individuals earn for being members of a pension scheme’.

Let’s look at an example for calculating your pension based on the accrual rate. If you’re earning £30,000 by the end of your employment, the accrual rate is 1/60th and you’ve been working there for 5 years, your annual pension will be £5,000. This is because you multiply 30,000 x 5 x 1/60. 

These days, this type of pension is rare and is usually seen within large corporations and the public sector.

What is a final salary and career average pension?

While researching on pensions and on several schemes, you'll realise that the defined benefit pension scheme is separated into two categories. It depends on how your pension provider will calculate your pension salary once you retire.

If your defined benefit pension is calculated based on:

  • your final salary that you were being paid at the end of your employment, then you get a final salary type of benefit pension.
  • the average of your salary throughout your career, then you get a career average type of benefit pension.

What are the benefits of a defined benefit pension scheme?

The defined benefit pension is a guaranteed income for life after your retirement. Members of this scheme are aware of the amount of pension money they will get as income for the rest of their retired years.

Your pension is also insured in case of any financial difficulty the company faces - you will receive your pension. However, there have been cases where pension providers run out of money and pension pots that were not insured against, were lost.

Tax-relief is also another perk of contributing to a pension pot. In some cases, defined benefit pensions schemes allow tax-free cash lump sum to withdraw as income. New pension rules state that it is possible to take a one-off 25% pension payment tax-free, while the rest will be taxed at your taxable income rate at the time.

When can I access my pension?

At the moment, you can access your pension - whether defined benefit or defined contribution one  - at the age of 55 and later. It is expected to rise at 57 in 2028. In contrast, the age you can claim a State Pension is 65 and older, depending on your date of birth.

Defined contribution pension scheme

What is a defined contribution pension scheme?

This scheme ensures that contributions are actively made into your pension - whether workplace or personal - instead of automatically contributing to your pot based on your salary or the years you’ve worked for the company.

This type of pension is either:

  • a personal pension arranged and managed by you
  • a workplace pension offered by your employer as a personal pension pot
  • or a workplace pension arranged by your employer and paid for by them.

This is the most well-known way of paying into a pension because it’s as if you save money into a savings account for your future self. Any type of pension that you, your employer or your family contribute into, it is a defined contribution pension scheme.

How much retirement money am I entitled to with this type of pension?

The amount of money you are entitled to receive in your retirement - based on contributions - depends on:

  • the contribution you paid into your personal pension pot
  • the contribution your employer paid into your personal pension pot
  • the contribution you paid into your workplace pension pot
  • the contribution your employer paid into your workplace pension pot
  • how well these investments did whether it is in your personal pot or workplace pot
  • And on tax relief you will receive it as a top-up.

Seems straightforward right?

What are the benefits of a defined contribution pension scheme?

Whether it is a personal pension arranged by you or your employer, you are in control of the amount of money you invest. Speak to your pension provider to arrange the contribution levels.

Also, because the money for your retirement depends on the amount paid in and on the value of the invested pension, you are entitled to receive the whole amount as your retirement fund, after tax. You should also consider the tax on your pension withdrawals after receiving 25% of it. By contributing into a pension pot you get several tax benefits whether that is a top up of money as tax-relief from the Government or the tax free 25% lump sum withdrawal you can initially take from your pension. 

For instance, if you have £500,000 saved in your pension and you decide to withdraw 25% of it,  that would be £125,000 tax-free. The remaining £375,000 will be taxed based on your income tax band.

Remember, this scheme is similar to a tax-efficient savings account!

What is the difference then between defined benefit and defined contribution pension?

The difference between a defined benefit pension and a defined contribution pension scheme is that depending on the type of pension you are investing in, the way you pay into them is different. The former depends on your salary and on how long you worked for, whereas the latter depends on how much was paid in the pot and how much the investment grew.

How Raindrop is here for you

Raindrop can help you find your lost pensions, whether they're a workplace or personal pension regardless of how you made payments into it. However, Raindrop can only help you consolidate defined contribution pension schemes into one simple pension scheme. This is because defined benefit pension schemes have safeguarded benefits and have different regulations and tax treatments.

Find your old pension today, don't leave it for another day.

Important information

Pensions are a long-term investment. The retirement benefits you receive from your pension plan will depend on a number of factors including the value of your plan when you decide to take your benefits which isn’t guaranteed and can go down as well as up. The value of your plan could fall below the amount(s) paid in.

The value of the tax benefits of your pension depend on your individual circumstances. Tax rules and circumstances may change in the future.

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If you are considering finding and combining your pensions into one place then Raindrop could be a good solution for you. If you choose to combine your pensions with Raindrop, as with all investments your capital is at risk. The value of your pension can go up as well as down.

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