Comparison of defined benefit and defined contribution pension schemes
Defined benefit schemes
A defined benefit (DB) pension scheme is one type of workplace pension scheme, in which an employer promises a specific pension payment, lump sum (or a combination of both) on retirement. The scheme trustees make all the investment decisions so there is no investment risk to the individual members.
This type of pension scheme is also commonly known as a ‘final salary’ scheme.
The benefits payable are predetermined using a number of factors, typically including, your earnings, the length of time that you have been a member of the scheme, your age and a rate of accrual determined by the scheme. The pension scheme will define what is meant by ‘earnings’, this could be basic pay and may not include overtime, commission or other benefits.
Defined benefit schemes may be based on your final salary or an average over your career whilst you have been a member (career average).
Defined benefit schemes pay out a secure income for life which typically increases each year. You might have a defined benefit pension if you’ve worked for a large employer or in the public sector.
Your employer contributes to the scheme and is responsible for ensuring there’s sufficient money within the scheme at the time you retire to pay your pension income. You may also be asked to contribute to the scheme. Any contributions you make are normally deducted from your salary before your income tax is calculated.
At retirement you will receive a pension income and potentially the option of a tax free lump sum. Many schemes will offer a reduced income if you wish to take a tax free lump sum payment, however some offer the tax free lump sum in addition to an income.
Where the total value of all of your pension benefits (the defined benefit pension and any other private pension plans that you may have) is £30,000 or less, you can take the whole of your defined benefit pension as a lump sum, currently 25% will be tax free and the remainder will be subject to tax at your marginal rate, this option is normally only available from age 55.
If you die when you are in receipt of your pension, a reduced pension will continue to be paid to your spouse or civil partner for their lifetime.
Depending on your employment history, you may also have one or more deferred DB pension schemes. This is where you have been a member of a DB pension scheme but may have left the company so you are no longer an active member and the benefits are ‘deferred’ until you retire or elect to transfer these benefits to a defined contribution scheme.
The value of a deferred pension in a DB pension scheme will continue to increase at least in line with inflation from the date of leaving the scheme up to your retirement age or when you take the scheme pension or elect to transfer out of the scheme.
Defined contribution schemes
A defined contribution scheme is a pension where you build up a pot of money which can be used to provide you with an income in retirement and can be in the form of a:
• For individuals – Personal pension plan (PP), Stakeholder Plans, Self Invested Personal Pensions (SIPPS), Retirement Annuity Contracts
• Through your workplace – Group personal pension(GPP), Group Stakeholder, Occupational Money Purchase Plans, Small Self-Administered Schemes (SSAS), Executive Pension Plans
You may have more than one of these.
You can get tax relief on personal pension contributions up to 100% of your annual earnings, unless you have already accessed some of your pension funds flexibly either through an Uncrystallised Fund Pension Lump Sum (UFPLS) or Flexi-Access Drawdown (FAD) and taken an income. In this case, you will be subject to the ‘money purchase’ annual allowance and your annual contribution will be limited to £4,000.
Defined contribution pension schemes invest the contributions, made by you and / or your employer in a range of different investments.
If you have a PP plan, you can choose your own contribution level and how your contributions are invested. If you pay Income Tax at a rate of 20% or less, your pension provider will automatically claim back 20% and add it to your pension pot. If you pay a higher rate of Income Tax, you will need to claim the additional tax yourself through your self-assessment return.
If you are a member of a workplace group personal pension scheme (GPP), the minimum contribution level will be determined by your employer but you are usually allowed to pay more than this, if you wish and you should be offered a choice on how the contributions are invested. Your own contributions are deducted from your salary after tax has been taken off and your contributions are paid net of basic rate tax relief (currently 20%).
Another type of workplace defined contribution scheme is the occupational money purchase scheme. Each member of the scheme doesn’t have their own individual policy and contributions may be deducted from salary before income tax is calculated.
Defined contribution pension schemes are also known as ‘money purchase schemes’.
Your pension pot is built up using your own and your employer’s contributions (if applicable) plus investment returns and tax relief.
The benefits available on retirement are dependent on:
• How much has been paid in on your behalf (by you and / or your employer)
• The length of time that monies have been invested and the fund’s investment performance, and
• The level of charges deducted from the plan
You can access and use your pension pot in any way you wish from age 55. You can also keep saving into your pension and get tax relief until you reach the age of 75. If you have accessed your pension plan and taken an income, ongoing contributions may be restricted to £4,000 per annum.
The options currently available when you access your plan are:
• Take your whole pension pot as a lump sum in one go. A quarter (25%) will be tax free (this may be higher if you have applied for tax free cash protection or scheme specific protection applies) and the rest will be subject to Income Tax and taxed in the usual way. Bear in mind that a large lump sum could tip you into a higher tax bracket for the year you take your lump sum.
• Take lump sums as and when you need them. A quarter of each lump sum will be tax free and the rest will be subject to Income Tax and taxed in the usual way. Bear in mind that a large lump sum could tip you into a higher tax bracket for the year.
• Take a quarter of your pension pot as a tax-free lump sum, then place the rest in a drawdown plan which allows the funds to remain invested and withdrawn as and when required (this might be to provide you with a regular taxable income or to make ad-hoc withdrawals). Bear in mind that a large lump sum could tip you into a higher tax bracket for the year.
• Take a quarter of your pot as a tax-free lump sum and then convert some or all of the rest into a taxable guaranteed income for life (known as an annuity).
Comparison of the main features
|Features||Defined benefit schemes||Defined contribution schemes|
|Contributions||Your employer contributes to the scheme and is responsible for ensuring there’s enough money at the time you retire, to pay your pension income.
You may be able to contribute to the scheme too.
|Defined contribution pensions build up a pension pot using your contributions and your employer’s contributions (if applicable) plus investment returns and tax relief.|
|Investment Choice||The scheme trustees make all the investment choices.||With a personal pension plan or group personal pension plan you can usually choose from a range of funds to invest in. With an occupational money purchase scheme the trustees normally make the investment decisions.|
|Flexibility||It’s not usually possible to reduce your contribution levels or suspend them. Contributions can usually be increased by using a separate plan (an additional voluntary contribution plan).||It’s often possible to increase and decrease contribution levels or stop them.
You can also change your investment choices on a regular basis with a group or personal pension plan.
|Security||Defined benefit schemes are protected by the Pension Protection Fund.||These schemes are usually covered by the Financial Services Compensation Scheme.|
|Charges||There are no explicit charges or fees.||These will vary from scheme to scheme and often include an annual management charge, policy fee and, particularly for older schemes, a bid / offer spread.|
|What happens if you leave your employment?||You will become a deferred member of your pension scheme so you will be entitled to benefits on your retirement in line with your period of employment.
You may transfer your accrued benefits to a new pension plan. Please note that if you were a member of a public service pension scheme, for example NHS or civil service, this may not be possible.
|Your fund will remain invested until your retirement. You could transfer the accrued fund to another pension provider. With personal pension plans it’s normally possible to continue your contributions, within allowable limits until age 75.|
|Benefits||Defined benefit schemes||Defined contribution schemes|
|Pension commencement lump sum||Some schemes offer a tax free lump sum in addition to a pension income, whilst others offer a reduced pension in return for the tax free lump sum.
The maximum lump sum is based on a combination of HM Revenue and Customs’ rules and those of the particular scheme.
|25% of the total pension fund can be taken as a tax free lump sum. (This may be restricted if your pension fund exceeds the current lifetime allowance of £1,055,000). This can normally either be taken in one go or in stages.|
|Income||Your pension income is based on: the number of years you have been in the scheme, your age, the scheme’s accrual rate and either your final or career average salary.
The scheme will pay the pension directly to you whilst you are living and it may increase annually, for example in line with Retail Price Index / Consumer Price Index but it will not reduce.
|You can choose how you take your pension income, you can withdraw the entire fund in one go or take income withdrawals at your chosen level. This level of income can increase, decrease or stop as required, however when the total fund is exhausted, you will be unable to take any further income. Or you can take a guaranteed income for life i.e. purchase a pension annuity.|
|Tax||Your income will be paid to you net of tax at your marginal rate via the PAYE system.||Your income will be paid to you net of tax at your marginal rate via the PAYE system.|
|Retirement age||You can usually take your pension from age 55.
However, if the scheme’s normal retirement date is higher, you may incur an early retirement penalty should you retire earlier than this age.
|You can usually take your pension from age 55 without penalty.|