Defined Benefit Pension
A defined benefit pension scheme – often called final salary pension scheme – is one that pays out an income based on how much you earn when you retire.
Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you – you won’t have to use your pension pot to plan how best to generate an income.
If you’ve saved into a final salary pension scheme, your savings, along with the contributions of your employer and the tax relief you receive from the government, have been invested in the stock market over your working years.
But the income you ultimately receive from your pension is a guaranteed, pre-agreed amount, hence the name ‘defined benefit’ pensions.
Types and benefits of a defined benefit pension
- Final salary schemes, based on how much you’re paid when you retire
- Career average schemes, based on an average of your salary across your career
Being a member of a defined benefit pension scheme comes with a range of benefits:
- DB pensions are indexed linked to price rise, some with an annual cap of 2.5% per year and some by tracking the Retail Price Index
- Death-in-service payments to spouses, partners or dependants if you die before reaching pensionable age.
- Full pension if you have to retire early through ill health
- Reduced pension if you retire early, although this can’t be done before the age of 55
Defined Contribution Pension
A defined contribution pension – sometimes called money purchase – is a type of workplace pension. It is built up through your own contributions, those of your employer and tax relief. The vast majority of company pension schemes are now defined contribution.
Defined contribution schemes give you an accumulated sum when you come to retire that you can use to secure a pension income through buying an annuity, or opt for income drawdown. You can also withdraw the cash as a lump sum – but may face a hefty tax bill.
How a DC scheme works
Prior to 2012, you would have been asked by your employer if you wanted to join the company scheme. However, since 2012 automatic enrolment was introduced, requiring all UK workplaces to enrol their staff. Your employer will deduct your contributions from your salary before tax and will usually contribute a percentage to your pension. You’ll also get tax relief from the government which will boost the pot.
The contributions from you and your employer will be invested in the stock market, with the aim of growing it before you retire. Members of defined contribution schemes have a degree of choice as to where their pension contributions are invested. For example younger savers could choose more risky investments to maximise growth, as they have many years of work ahead.
Types of DC schemes
These types of pension schemes are run by a board of trustees that oversees the management and investments in your pension. The trustees choose the professionals who look after your money and have a duty to you as the member of the scheme to get the best deal.
If you’re in a contracted-based pension, it means that your employer has appointed a pension provider to run your pension scheme. These are sometimes called ‘group personal pensions.’ These types of schemes often offer you a much greater choice in investments for your pension savings than a trust-based scheme.